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Adverse Selection and Liquidity Distortion in Decentralized Markets

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  • Briana Chang

    (Northwestern University)

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    Abstract

    This paper studies the competitive equilibrium outcome in decentralized asset markets when both search friction and adverse selection play roles. In a dynamic environment with heterogeneous sellers and buyers, I show how adverse selection leads to the downward distortion of equilibrium market liquidity. The model predicts a strong link between the market liquidity and the underlying uncertainty stemming from adverse selection and therefore provides an explanation for the existence of massive illiquidity. As our setup captures two important dimensions in the trading market, price and liquidity, it shows how price and liquidity are jointly determined as an equilibrium outcome and further sheds lights on market segmentation. The framework also allows for a richer analysis of how sorting pattern is determined in such an environment and how different market segmentation may arise when sellers' motives for sale are unknown to the market.

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    File URL: http://www.economicdynamics.org/meetpapers/2011/paper_157.pdf
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    Bibliographic Info

    Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 157.

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    Date of creation: 2011
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    Handle: RePEc:red:sed011:157

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    1. Robert Shimer & Randall Wright & Veronica Guerrieri, 2009. "Adverse Selection in Competitive Search Equilibrium," 2009 Meeting Papers 139, Society for Economic Dynamics.
    2. Jan Eeckhout & Philipp Kircher, 2010. "Sorting and Decentralized Price Competition," Econometrica, Econometric Society, vol. 78(2), pages 539-574, 03.
    3. Milgrom, Paul & Shannon, Chris, 1994. "Monotone Comparative Statics," Econometrica, Econometric Society, vol. 62(1), pages 157-80, January.
    4. Vojislav Maksimovic, 2001. "The Market for Corporate Assets: Who Engages in Mergers and Asset Sales and Are There Efficiency Gains?," Journal of Finance, American Finance Association, vol. 56(6), pages 2019-2065, December.
    5. Thorsten V. Koeppl & Jonathan Chiu, 2010. "Market Freeze and Recovery: Trading Dynamics under Optimal Intervention by a Market-Maker-of-Last-Resort," 2010 Meeting Papers 78, Society for Economic Dynamics.
    6. Moen, Espen R, 1997. "Competitive Search Equilibrium," Journal of Political Economy, University of Chicago Press, vol. 105(2), pages 385-411, April.
    7. Shi, Shouyong, 2001. "Frictional Assignment. I. Efficiency," Journal of Economic Theory, Elsevier, vol. 98(2), pages 232-260, June.
    8. Pierre-Olivier Weill, 2004. "Liquidity Premia in Dynamic Bargaining Markets," Econometric Society 2004 North American Winter Meetings 648, Econometric Society.
    9. Ricardo Lagos & Guillaume Rocheteau, 2008. "Liquidity in asset markets with search frictions," Staff Report 408, Federal Reserve Bank of Minneapolis.
    10. Nicholas Bloom, 2009. "The Impact of Uncertainty Shocks," Econometrica, Econometric Society, vol. 77(3), pages 623-685, 05.
    11. Ruediger Bachmann & Christian Bayer, 2009. "The Cross-section of Firms over the Business Cycle: New Facts and a DSGE Exploration," CESifo Working Paper Series 2810, CESifo Group Munich.
    12. Yoonsoo Lee & Toshihiko Mukoyama, 2008. "Entry, Exit, and Plant-Level Dynamics over the Business Cycle," Working Papers 08-17, Center for Economic Studies, U.S. Census Bureau.
    13. Warusawitharana, Missaka, 2008. "Corporate asset purchases and sales: Theory and evidence," Journal of Financial Economics, Elsevier, vol. 87(2), pages 471-497, February.
    14. Darrell Duffie & Nicolae Garleanu & Lasse Heje Pedersen, 2005. "Over-the-Counter Markets," Econometrica, Econometric Society, vol. 73(6), pages 1815-1847, November.
    15. Douglas Gale, 1996. "Equilibria and Pareto optima of markets with adverse selection (*)," Economic Theory, Springer, vol. 7(2), pages 207-235.
    16. Eisfeldt, Andrea L. & Rampini, Adriano A., 2006. "Capital reallocation and liquidity," Journal of Monetary Economics, Elsevier, vol. 53(3), pages 369-399, April.
    17. Gavazza, Alessandro, 2010. "The role of trading frictions in real asset markets," MPRA Paper 25781, University Library of Munich, Germany.
    18. Dale T. Mortensen & Randall Wright, 2002. "Competitive Pricing and Efficiency in Search Equilibrium," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 43(1), pages 1-20, February.
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    Cited by:
    1. Enchuan Shao, 2013. "The Threat of Counterfeiting in Competitive Search Equilibrium," Working Papers 13-22, Bank of Canada.

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