Prices Are Less Elastic For Less Diversifiable Demand

Abstract

We hypothesize and provide evidence that prices are more inelastic when demand is less diversifiable. Specifically, we decompose order-flow imbalance into several components with varying degrees of diversifiability and estimate their price impacts. The results reveal a continuum of price elasticities ranging from high elasticities at style/factor levels to low elasticities at idiosyncratic levels. Our findings are consistent with weaker liquidity pro- vision at less diversifiable levels—which may arise from investor risk aversion or portfolio constraints—and inconsistent with information-based price-impact mechanisms. Our findings might explain why “discount rate variation” matters to a greater extent as the level of aggregation rises.

Keywords: Price elasticity, liquidity provision, demand-based asset pricing

JEL Classification: G11, G12