(De)regulation and market thickness

Abstract

Regulation is a set of constraints imposed on transactions between buyers and sellers. We introduce a dynamic frictional matching model with horizontal differentiation and nontransferable utility in which a regulator determines permissible transactions. We show the existence and uniqueness of a market equilibrium for any level of regulation and characterize the regulator's optimal choice of regulatory environment. We argue that in 'thin', markets, regulation can correct market failure arising from mismatch between buyers and sellers. However, in 'thick' markets, deregulation is optimal, as a regulator can rely on market participants' equilibrium behavior instead of explicit constraints on economic activities.