Liquidity and Congestion

Gara Minguez Afonso
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Gara Minguez Afonso: LSE / Princeton University

No 926, 2008 Meeting Papers from Society for Economic Dynamics

Abstract: This paper studies the relationship between the arrival of potential investors and market liquidity in a search-based model of asset trading. The entry of investors into a specific market causes two contradictory effects. First, it reduces trading costs, which then attracts new investors (thick market externality effect). But secondly, as investors concentrate on one side of the market, the market becomes “congested”, decreasing the returns to participating in this market and discouraging new investors from entering (congestion effect). The equilibrium level of market liquidity depends on which of the two effects dominates. When congestion is the leading effect, some interesting results arise. In particular, we find that diminishing trading costs in our market can deteriorate liquidity and reduce welfare.

Date: 2008
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed008:926

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