Conferences at Department of Economics, University of Toronto, Canadian Economic Theory Conference 2009

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Search with Adverse Selection

Stephan Lauermann*, Asher Wolinsky

Date: 2009-05-15 4:30 pm – 5:00 pm
Last modified: 2009-04-17

Abstract


This paper explores a dynamic model of adverse selection in which trading partners receive noisy information. A monopolistic buyer wants to procure service. Seller's cost depend on the buyer's type. The buyer contacts sellers sequentially and enters into a bilateral bargaining game. Each seller observes the buyer's offer. In addition, each seller observes a noisy signal. Contacting sellers (search) is costly. We characterize equilibrium when search cost become small. In the limit, the price will depend in a simple way on the curvature of the signal distribution. If signals are sufficiently strong, the limit outcome is equivalent to the full information outcome. (The equilibrium is separating and prices are equal to the true cost.) If signals are weak, the limit outcome is equivalent to an outcome with no information. (The equilibrium is pooling and prices are equal to ex ante expected cost.) The efficiency of the limit is closely tied to whether or not limit prices are separating or pooling. Intuitively, search cost reduce the winner's curse by reducing excessive search by bad types. Away from the limit, a dynamic model of adverse selection with noisy information has several natural implications for the correlation between duration, quality, and prices. Most importantly, in many equilibria it will be the "lemons" that stay in the market for a long time, while good types trade fast. This is in accord with stylized facts about the housing or the labor market.

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