A LIMIT OF BILATERAL CONTRACTING INSTITUTIONS

I. INTRODUCTION The double auction (DA) institution has a solid and deserved reputation as the archetypal efficient market institution. Beginning with Smith (1962), 30 years of experimental research shows that the DA achieves very high and stable efficiency for a wide variety of underlying market structures (Davis and Holt 1993). The DA resembles many naturally occurring market institutions, including some of the world's largest financial exchanges. In the DA, any agent may at any time unilaterally make a price/quantity quote to other agents, revise his or her quote, or accept an outstanding quote made by another agent. These actions occur publicly at some central location (whether spatial or electronic), so all traders may continuously view quote and contract activity. In both the field and the laboratory, these basic rules are often augmented with bid-ask improvement rules, variations on the display of bid-ask queues (or books), limit orders, and so on; many of these augmentations improve the DA's price stability and trading efficiency (Smith and Williams 1982). But more recent studies (e.g., Banks et al. 1989; Van Boening and Wilcox 1996) show that the DA has its limits. In particular, it fails to produce stable and efficient allocations when market structures contain nonstandard preferences and/or technological features, particularly when markets are relatively thin. In our own previous work, the nonconvexity of batch production was the source of the difficulty. Walrasian equilibria do not always exist in this case, and the DA is inefficient in those situations. This article describes our attempt to generalize the DA institution so that it might encourage efficient nonuniform pricing in such situations. Taken at face value, this attempt must be judged a failure, and other past attempts to solve this problem (Durham et al. 1996; Archibald et al. 2002) have not been wholly satisfying either. Yet examination of these results and the process of elimination strongly suggest that an implicit restriction to bilateral contracting is an essential part of the received DA's limitations. As we have briefly described it, the DA may initially appear to be the very essence of free contracting. But it does not provide a mechanism whereby three or more agents may simultaneously negotiate and then enter into a mutually agreeable multiagent contract. All contracts are necessarily bilateral ones under the DA and, in fact, under almost all conventional marketlike institutions. In market structures where preferences and technologies are convex, the restriction to bilateral contracts is generally unimportant, but when nonconvexities are severe, it may be impossible to reliably achieve efficiency under the constraint of bilateral contracting (Telser 1987). In this article, we show this is true even if the DA is modified so that bilateral negotiation and contracting possibilities are made particularly rich. We believe these results have important policy implications. Privatization and deregulation initiatives have gained momentum around the globe over the past 20 years, and many economists, including us, have little doubt of their potential for good. Nonetheless, poorly articulated calls for regulation by the market carry an unnecessary potential for harm. Although the possible institutional rules governing negotiation and contracting under private property come in nearly infinite varieties, "regulation by the market" typically means the adoption of traditional bilateral contracting institutions like the DA. Yet there are good theoretical reasons to doubt that these are always the best choice (Telser 1987), and accumulating experimental evidence supports these doubts. Moreover, there are now promising alternatives to traditional bilateral contracting institutions that outperform the DA in several nonstandard structural situations (Bossaerts et al. 2002; Bykowski et al. 2000; Ishikida et al. 2001). We conclude that calls for regulation by the market are sometimes too vague to unambiguously serve the public interest. …