Endogenous market power and asset pricing in thin financial markets

Empirical evidence demonstrates that large institutional investors have significant price impact in financial markets. The existing asset pricing models, however, assume that all traders are price takers. The goal of my dissertation is to develop a general equilibrium model to study these and other non-competitive markets.; In the first chapter I present a general equilibrium framework for studying interactions in non-competitive economy. The model does not discriminate between consumers and producers, and all traders react optimally in and out of equilibrium (features that Cournot-Nash equilibrium lacks). A trader's deviation from equilibrium quantity is followed by a price change sufficient to encourage all other traders to absorb the deviation. This price response defines a downward sloping demand curve facing each trader that is taken into account when trading. I show that equilibrium defined in this way exists and is determinate. The model defines equilibrium prices and quantities even in markets with producers having increasing returns to scale or a bilateral monopoly. I use the model to study the determinants of market power and the effects of non-competitive trading on equilibrium allocation, prices and welfare. The trader's market power depends on the convexity of preferences of trading partners. Non-competitive trading reduces the volume of trade and the sign of price bias depends on traders' prudence.; In the second chapter, I apply the framework to model thin financial markets, i.e., markets with a small number of institutional investors. Since in such markets investors have market power, the competitive asset pricing models, such as CAPM, cannot be used. I derive an asset-pricing formula, explicitly modeling the price impacts of institutional traders. I also show that thin trading results in insufficient hedging of risk. In the presence of price impacts, cash value and market capitalization of a company no longer coincide. Therefore I also derive the formula for discounting the value of a portfolio for blockages (blockage discounts).; In the third chapter, co-authored with Marzena Rostek, we develop a dynamic model of thin markets, where we study the time structure of price impacts. The results match a number of empirical facts that cannot be reconciled with competitive trading, such as breaking up orders into smaller blocks, asset-price overshooting and evolution of market liquidity.