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

Research output: Contribution to journalArticlepeer-review

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.

Original languageEnglish (US)
Pages (from-to)101-132
Number of pages32
JournalEnvironmental and Resource Economics
Volume82
Issue number1
DOIs
StatePublished - May 2022

Keywords

  • groundwater
  • Q15
  • Q25
  • Q59
  • Search frictions
  • Tradable permit markets
  • Transaction costs
  • Water markets

ASJC Scopus subject areas

  • Economics and Econometrics
  • Management, Monitoring, Policy and Law

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