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Transaction Costs and Informational Cascades in Financial Markets: Theory and Experimental Evidence

  • Marco Cipriani

    (George Washington University)

  • Antonio Guarino

    (University College London)

We study the effect of transaction costs (e.g., a trading fee or a transaction tax, like the Tobin tax) on the aggregation of private information in financial markets. We analyze a financial market à la Glosten and Milgrom, in which informed and uninformed traders trade in sequence with a market maker. Traders have to pay a cost in order to trade. We show that, eventually, all informed traders decide not to trade, independently of their private information, i.e., an informational cascade occurs. We replicated our financial market in the laboratory. We found that, in the experiment, informational cascades occur when the theory suggests they should. Nevertheless, the ability of the price to aggregate private information is not significantly affected.

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Paper provided by ESRC World Economy and Finance Research Programme, Birkbeck, University of London in its series WEF Working Papers with number 0008.

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Date of creation: Mar 2006
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Handle: RePEc:wef:wpaper:0008
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  1. Gale, Douglas, 1996. "What have we learned from social learning?," European Economic Review, Elsevier, vol. 40(3-5), pages 617-628, April.
  2. Glosten, Lawrence R. & Milgrom, Paul R., 1985. "Bid, ask and transaction prices in a specialist market with heterogeneously informed traders," Journal of Financial Economics, Elsevier, vol. 14(1), pages 71-100, March.
  3. Avery, Christopher & Zemsky, Peter, 1998. "Multidimensional Uncertainty and Herd Behavior in Financial Markets," American Economic Review, American Economic Association, vol. 88(4), pages 724-48, September.
  4. Marco Cipriani & Antonio Guarino, 2005. "Herd Behavior in a Laboratory Financial Market," Experimental 0502002, EconWPA.
  5. Ian Domowitz & Jack Glen & Ananth Madhavan, 2000. "Liquidity, Volatility, and Equity Trading Costs Across Countries and Over Time," William Davidson Institute Working Papers Series 322, William Davidson Institute at the University of Michigan.
  6. David Hirshleifer & Siew Hong Teoh, 2003. "Herd Behaviour and Cascading in Capital Markets: a Review and Synthesis," European Financial Management, European Financial Management Association, vol. 9(1), pages 25-66.
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