Endogenous Market Formation and Monetary Trade: An Experiment

Abstract

Abstract The theory of money assumes decentralized bilateral exchange and excludes centralized multilateral exchange. However, endogenizing the exchange process is critical for understanding the conditions that support the use of money. We develop a “traveling game” to study the emergence of decentralized and centralized exchange, theoretically and experimentally. Players located on separate islands can either trade locally, or pay a cost to trade elsewhere, so decentralized and centralized markets can both emerge in equilibrium. The former minimize trade costs through monetary exchange; the latter maximizes overall surplus through nonmonetary exchange. Monetary trade emerges when coordination is problematic, whereas centralized trade emerges otherwise. This shows that to understand the emergence of money it is important to amend standard theory such that the market structure is endogenized.