Things get even more interesting when transaction costs influence your upfront willingness to purchase assets. You might not want to purchase a house even if you expect to recoup your transaction cost, because you dislike the fact that you do not know whether it will be easy or hard to resell. After all, if you purchase a stock or bond instead, you know you can resell without much transaction cost whenever you want.
So, why would you want to take the risk of sitting on a house for months without being able to sell it? To get you to purchase a house would require the seller to compensate you. The seller would have to offer you a liquidity premium—an extra expected rate of return—to induce you to purchase the house. The liquidity analogy comes from physics. The same way that physical movement is impeded by physical friction, economic transactions are impeded by transaction costs. Financial markets are often considered low-friction, or even close to frictionless. And when the amount of trading activity subsides, pros would even say that “the market has dried up.”
Housing may be an extreme example, but liquidity effects seem to be everywhere and important— and even in financial markets with their low transaction costs. A well-known and startling example is Treasury bonds. One bond is designated to be on-the-run, which means that everyone who wants to trade a bond with roughly this maturity (and the financial press) focuses on this particular bond. This makes it easier to buy and sell the on-the-run bond than a similar but not identical off-the-run bond. For example, in November 2000, the 10-year on-the-run Treasury bond traded for a yield-to-maturity of 5.6% per annum, while a bond that was just a couple of days off in terms of its maturity (and thus practically identical) traded at 5.75% per annum. In other words, you would have been able to purchase the off-the-run bond at a much lower price than the on-the-run bond. The reason why you might want to purchase the on-the-run bond, even though it had a higher price, would be that you could resell it much more quickly and easily than the equivalent off-the-run bond. Of course, as the date approaches when this 10-year bond is about to lose its on-the-run designation and another bond is about to become the on-the-run 10-year bond, the old on-the-run bond drops in value and the new on-the-run bond increases in value.
The provision of liquidity in markets of any kind is a common business. For example, you can think of antique stores or second-hand car dealerships as liquidity providers that try to buy cheap (being a standby buyer), and try to sell expensive (being a standby seller). Being a liquidity provider can require big risks and capital outlays. If it was easy, everyone could do it–and then there would be no more money in liquidity provision!