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Trading Dynamics in Decentralized Markets with Adverse Selection

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  • Ben Lester

    (University of Western Ontario)

  • Braz Camargo

    (Sao Paulo School of Economics - FGV)

Abstract

We study a dynamic, decentralized market environment with asymmetric information and interdependent values between buyers and sellers, and characterize the complete set of non-stationary equilibria. For a given fraction of low-quality assets, or ``lemons,'' the model describes how prices, the volume of trade, and the composition of assets will evolve over time. Comparing economies in which the initial fraction of lemons varies, the model delivers a stark relationship between the severity of the lemons problem and market liquidity. We use this framework to understand how asymmetric information has contributed to the ``frozen'' credit market at the core of the current financial crisis, and to evaluate the efficacy of one of the policies that was implemented in attempt to restore liquidity.

Suggested Citation

  • Ben Lester & Braz Camargo, 2011. "Trading Dynamics in Decentralized Markets with Adverse Selection," 2011 Meeting Papers 1300, Society for Economic Dynamics.
    • Handle: RePEc:red:sed011:1300
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    More about this item

    JEL classification:

    • C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games
    • C78 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Bargaining Theory; Matching Theory
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
    • G1 - Financial Economics - - General Financial Markets

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