Trading Volume, Asset Price and Flexible Transaction Cost

Abstract

We extend Blume, Easley and O'Hara (1994)'s model to a world with flexible transaction cost. We find out the non-linear equilibrium price and volume and show that trading volume provides to uninformed traders useful information on the asset fundamental which cannot be inferred from the equilibrium price. We further demonstrate how transaction cost influences trading volume and the equilibrium price in very different ways. While transaction cost always reduces trading volume, its influence decreases at the margin. The impact of transaction cost on the equilibrium price is much more complicated since its effects on the demand of informed and uninformed traders are inverse. Whether the equilibrium price with transaction cost is higher or lower than that without transction cost depends upon which effect dominates.