Endogenous Market Thinness and Stock Price Volatility

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Abstract
Thin equity markets cannot accommodate temporary bulges of buy or sell orders without large price movements. The resulting volatility can induce risk-averse transactors who face transaction costs to desert these markets. Thus thinness and the related price volatility may become joint self-perpetuating features of an equity market, irrespective of the volatility of asset fundamentals. If, however, appropriate incentive schemes are adopted to encourage entry by additional investors, this vicious circle can be broken, eventually shifting the market to a self-sustaining, superior equilibrium characterized by a higher number of transactors, lower price volatility and larger supply of the asset.

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