Market Microstructure and Informational Efficiency Rafael R. Guthmann and Brian C. Albrecht
Coles Working Paper Series, FALL20-03, November 2020
Overview Building on the ideas of Nobel laureate F. A. Hayek, many economists, such as Nobel laureate Leo Hurwicz, have formally shown that competitive markets require little information to allocate goods efficiently. If people know only the prices of goods that they want to buy and sell, they can achieve an efficient outcome. However, the standard formulation of competitive markets neglects their underlying microstructure; nobody actually sets the prices, which provide all necessary information. Our paper reconsiders the informational efficiency of markets by modeling two with different microstructures. In the first and most commonly studied, people must search for their trading partners. In the second, market-makers connect buyers and sellers. We prove that while a search market can allocate goods as efficiently as a competitive market, it requires much more information to do so. Search is informationally inefficient; every buyer must know every seller’s expected price. In an economy with market-makers, buyers and sellers only need to need to know the price of a few market-makers. Less abstractly, buyers require less information if they can go on Amazon and find the going rate for a product than if they must search myriad online shops.
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