Abstract

Previous research suggests that a decline in transactions costs leads to improved economic efficiency. In this paper, we show that such a decline will introduce increasingly uninformed consumers into established markets. Using a model of financial market inefficiency, we show that this increase in uninformed individuals can increase market risk (volatility), can decrease efficiency, and may reduce social welfare even when market participantsareperfectlyrational. Wethentestthepredictionsofourmodelusingdataontheretailequities market. Our results suggest that securities that have a large proportion of small trades (presumably dispro- portionately from small, online retail investors) tend to be less efficient by conventional measures, consistent with our model predictions.

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