Market Microstructure and Informational Efficiency: The Role of Intermediation

Abstract

The competitive market is informationally efficient; people only need to know prices to implement a competitive allocation. However, the standard formulation of competitive markets assumes that prices are not set by strategic agents but by "supply and demand" and thus neglects the underlying role of market microstructure. We show that if prices are determined by strategic agents, then intermediation is necessary for markets to achieve informational efficiency. We study two specific market microstructures: a model where trade is intermediated by market-makers and a model of random matching and bargaining. First, we show that an economy where competition among market-makers determines prices can approximate the informational efficiency of the competitive model. Second, we show that as the complexity of the economy increases, matching markets require infinitely more information than the competitive market.

Keywords: allocation mechanisms, informational efficiency, search equilibrium, market-makers, intermediation

JEL Classification: C78, D40, D60, D82, D83