Liquidity and Price Dispersion in Markets with Information Heterogeneity

Abstract We consider asset markets where quality is heterogeneous and buyers have different ability to evaluate quality. In particular, we allow sellers to set up markets indexed by asking prices and buyers direct their search into different markets. We construct an equilibrium that features pooling on the sellers' side and separation on the buyers' side. A buyer without expertise in asset evaluation will search in a high-price market that contains more good assets. On the other hand, a buyer with expertise will search in a low-price market. The low-price market will be polluted with more bad assets, but the buyer can use his expertise to pick out the good assets and reject the bad ones. In equilibrium, the probability for a seller to meet a buyer decreases in asking price, and sellers with a bad asset are further rationed due to rejections by expert buyers. The model predicts that a larger share of bad assets is associated with a worsening of asset liquidity and an exacerbation of price dispersion.