Waiting for News in the Dynamic Market for Lemons

Joint with: Brendan Daley

Trade breaks down in the market for lemons because high-type sellers have a reservation value greater than expected market value. Unraveling occurs and only the lowest types trade. Two related questions arise: What happens the next day? And, from where does the reservation value come? We model these considerations in a dynamic setting with gradual arrival of noisy information. We characterize the unique equilibrium in a continuous-time framework. The equilibrium involves a region of no trade or market failure. The no-trade region ends in one of two ways: either enough good news arrives restoring confidence and markets re-open or bad news arrives making buyers more pessimistic forcing market capitulation i.e., a sell-off of low value assets. Reservation values arise endogenously from the option to sell in the future. Our model also encompasses dynamic signaling environments. In a dynamic setting with sufficiently informative news, Spences Job Market Signaling and Akerlofs Market for Lemons have the same unique equilibrium. The predictions help explain "irrational" trading patterns in financial markets.

For more information, contact Jing Li.