Markets and Institutions: A Matching Approach

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Ramey 9630270 Economists have long been concerned with the tradeoffs between market and nonmarket institutions with respect to carrying out transactions. The proposed research breaks new ground by explicitly analyzing the impact of market interaction on the determination and performance of agent-specific trading institutions, based on three key hypotheses: (1) forming productive relationships requires that agents meet with other agents in a matching process that reflects market interaction; (2) newly-matched agents make investments that are specific to their relationship and that cannot be contracted upon explicitly; and (3) productive relationships continue through time and require ongoing effort that is also not contractible. The key insight is that market forces shape trading relationships through their effect on the agents' incentives to provide ongoing effort. The research develops a mathematical general-equilibrium framework consisting of (1) models of bilateral investment and trading under a variety of organizational forms; (2) a matching model reflecting possibilities for asymmetries, search effort and inflow of new agents; and (3) a model of the capital market in which agents obtain resources needed for specific investment as well as creation of new productive assets. This develops a preliminary version of the framework, and reports a range of new analytical results illustrating the power of the approach. First, market forces can counteract the underinvestment incentive deriving from incomplete contractibility of investment, and first-best efficiency can emerge at a positive level of market friction. second, reducing market friction can have adverse short-run welfare effects by destabilizing existing trading relationships, and such reductions can also minimize long-run welfare. Third, market forces affect agents choice of integrated versus nonintegrated organizational forms. The project studies organizational form, matching, renegotiation and welfare in settings characteri zed by uncertainty and/or incomplete information regarding the quality of productive relationships, as well as applications to issues in macroeconomics, including economic growth, policy propagation and nominal rigidity.