Constrained Efficiency with Adverse Selection and Directed Search

Abstract

Constrained efficient allocation (CE) is characterized in a model of adverse selection and directed search (Guerrieri, Shimer, and Wright (2010)). CE is defined to be the allocation that maximizes welfare, the ex-ante utility of all agents, subject to the frictions of the environment. When equilibrium does not achieve the first best (the allocation that maximizes welfare under complete information), then welfare in the CE is strictly higher than welfare in the equilibrium allocation. That is, equilibrium is not constrained efficient. Under some conditions, welfare in the CE even attains welfare in the first best. Finally, sufficient conditions are provided under which equilibrium is not constrained Pareto efficient, either. Cross-subsidization is the key to all these results. In an asset market application, the first best is shown to be implementable through tax schedules that are monotone in the asset prices.

Adverse Selection with Heterogeneously Informed Agents

“…For other papers in monetary economics with a similar buyers' heterogeneity, see Williamson and Wright (1994) and Li (1998). My paper is also related to directed search literature with information frictions, e.g., Guerrieri, Shimer, and Wright (2010), Delacroix and Shi (2013) and Davoodalhosseini (2017). Search is directed in my paper, but terms of trade are not posted;…”

Directed Search and Competitive Search Equilibrium: A Guided Tour

“…Guerrieri, Shimer, and Wright (2010); Shao (2014); Chang (2018); Shimer (2014, 2018); Chen, Doyle, and Gonzalez (2015); Williams (2019); and Davoodalhosseini (2019) all consider screening problems à la Akerlof (1970). Consider Guerrieri, Shimer, and Wright (2010), a static environment with, in their language, homogenous principals and heterogeneous agents.…”

“…As might be expected with adverse selection (e.g., based on Mirrlees 1971), individual rationality is binding for low-quality sellers, incentive compatibility is binding for high-quality sellers, and equilibrium features less trade in the submarket with high quality. Equilibrium is not generally efficient, although taxes can correct the inefficiencies (Davoodalhosseini 2019). Guerrieri and Shimer (2014) study dynamic markets with heterogenous assets.…”

Competing mechanisms in markets for lemons

“…• The remaining fraction 1 − γ ∈ (0 1] of buyers post a price p l < p h and attract only low-type sellers. 38 As Davoodalhosseini (2018) shows, if adverse selection is sufficiently severe, a planner can improve on the competitive search equilibrium allocation by taxing the high-quality market and subsidizing the lowquality market. The cross-subsidization relaxes the incentive compatibility constraint of low-type sellers and thereby allows more trades of the high-quality good.…”