Working Paper: CEPR ID: DP142
Authors: Marco Pagano
Abstract: The existence of a centralized market does not in itself guarantee that an asset can be readily liquidated at no loss: if the market is not deep enough, traders will experience adverse changes in the market price in response to their transactions. Market depth, however, is a function of the entry decisions of all potential traders. Each trader will therefore judge the absorptive capacity of the market on the basis of his conjectures about the behaviour of the others. This creates an externality, and as often happens in situations where externalities are at work, multiple (rational expectations) equilibria are possible. The nature of the equilibrium which results depends on the initial conjectures that each trader forms about the choices of the others. If conjectures are "pessimistic", for instance, a market may remain trapped at an inefficient equilibrium, characterized by low trading volume and low liquidity.
Keywords: asset markets; trading volume; market thinness; liquidity; multiple equilibria; rational conjectures; externalities; entry decisions
JEL Codes: 022; 024; 026; 311; 313
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| trading volume (G15) | market prices (P22) |
| traders' expectations about market depth (D84) | trading behavior (G41) |
| low liquidity (G19) | low-trade low-liquidity trap (F16) |
| high liquidity (E41) | high-trade high-liquidity equilibrium (D53) |
| traders' beliefs in higher liquidity (E41) | active engagement in trading (F10) |
| traders' expectations of low liquidity (E41) | withdrawal from market (D49) |