| 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 (the thick market
externality effect). But second, 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
(what we call the 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 impair liquidity and reduce
welfare. |