Review of Finance Advance Access first published online on July 6, 2007
This version published online on July 9, 2007
Review of Finance, doi:10.1093/rof/rfm011
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Learning, Cascades, and Transaction Costs*
University of Salerno and CSEF, Italy
The paper analyzes the effect of transaction costs on social learning in an asset market with asymmetric information, sequential trading, and a competitive price mechanism. Both fixed and proportional transaction costs reduce the information content of trading orders and lead to informational cascades. If transaction costs are very high, an informational cascade may occur not only when beliefs converge on a specific asset value but also when there is extreme uncertainty about the asset's fundamental value. Finally, if the value in the bad state is sufficiently low, proportional transaction costs lead to an informational cascade only when prices are very high.
JEL Classification: D82, D83, G10
* I am grateful to Jean-Paul Decamps for his early input on this work. I would like to thank Abhijit Banerjee, Marcello D'Amato, Amil Dasgupta, Riccardo Martina, Marco Pagnozzi, Salvatore Piccolo, seminar participants at CSEF, University of Salerno, and an anonymous referee for comments and suggestions. The paper was improved by the helpful discussions with Alberto Bennardo and Marco Pagano.