Adverse Selection and Liquidity Distortion in Decentralized Markets

Briana Chang
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Briana Chang: Northwestern University

No 157, 2011 Meeting Papers from Society for Economic Dynamics

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.

Date: 2011
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