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The Role of Search Frictions and Trading Ratios in Tradable Permit Markets

Author

Listed:
  • Mani Rouhi Rad

    (Clemson University)

  • Taro Mieno

    (University of Nebraska)

  • Nicholas Brozović

    (University of Nebraska
    University of Nebraska)

Abstract

Search frictions, defined as the costs of finding trading partners, are a common feature of most permit markets. In these markets prices are not publicly available, buyers and sellers need to find their trading partners, trades often take place bilaterally, and there is often no central market-clearing mechanism. In this paper, we study the search and trading decisions of participants in a permit market with search frictions. We build an analytical model of the trading decision in a market with search frictions and show that individuals set a reservation price and an optimal search effort. The model shows that in the presence of search frictions, those who intend to trade (buy or sell) greater quantities search more. This trading behavior is not expected in a market without search frictions. Furthermore, we show that trading ratios affect the probability of trades taking place. We test the predictions of the model using a unique dataset of trades from a groundwater market with trading ratios that was designed to reduce a spatially explicit externality. We find that search frictions are significant so that buyers or sellers who trade greater quantities search more. Furthermore, we show that while the trading ratio system provides incentives to participants to reduce the spatial externality, search frictions reduces the effectiveness of the market by affecting the pool of potential trading partners for participants in the market.

Suggested Citation

  • Mani Rouhi Rad & Taro Mieno & Nicholas Brozović, 2022. "The Role of Search Frictions and Trading Ratios in Tradable Permit Markets," Environmental & Resource Economics, Springer;European Association of Environmental and Resource Economists, vol. 82(1), pages 101-132, May.
    • Handle: RePEc:kap:enreec:v:82:y:2022:i:1:d:10.1007_s10640-022-00664-3
    DOI: 10.1007/s10640-022-00664-3
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