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Liquidity and Congestion

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  • Gara Minguez Afonso

    (LSE / Princeton University)

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.

Suggested Citation

  • Gara Minguez Afonso, 2008. "Liquidity and Congestion," 2008 Meeting Papers 926, Society for Economic Dynamics.
    • Handle: RePEc:red:sed008:926
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    References listed on IDEAS

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    Cited by:

    1. Pierre-Olivier Weill & Bruno Biais, 2009. "Liquidity shocks and order book dynamics," 2009 Meeting Papers 89, Society for Economic Dynamics.
    2. Guillaume Rocheteau & Pierre‐Olivier Weill, 2011. "Liquidity in Frictional Asset Markets," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 43(s2), pages 261-282, October.
    3. Lagos, Ricardo & Rocheteau, Guillaume & Weill, Pierre-Olivier, 2011. "Crises and liquidity in over-the-counter markets," Journal of Economic Theory, Elsevier, vol. 146(6), pages 2169-2205.

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