Market Microstructure and Informational Complexity

Abstract

Competitive markets feature minimal informational complexity; agents only need to know prices to implement an efficient allocation. However, the standard formulation of competitive equilibrium neglects the mechanism of price formation, treating prices as exogenous. Here, we study explicit price formation mechanisms: trade intermediated by market-makers and trade via search and bargaining. We find that as the number of types in the economy grows, the informational complexity of random search diverges to infinity relative to the competitive market. This divergence can be avoided if market makers intermediate trade. Thus, this analysis provides a novel rationale for organized markets if agents' capacity to manage informational complexity is bounded.