Welfare Consequences of Information Aggregation and Optimal Market Size

This paper studies a risk-sharing model where traders face endowment shocks and information asymmetries. We show that a negative participation externality arises due to the endogenous information aggregation by prices, and it creates a counter force to a standard positive externality of risk-sharing. As a result, the optimal market size that maximizes gains from trade per trader is ?nite. The model indicates that a collection of small markets can be a constrained e¢ cient market structure. We also study a decentralized process of market formation, and show that multiple markets can survive because of the negative informational externality among traders.