Constrained Efficiency with Adverse Selection and Directed Search

The constrained efficient allocation (CE) is characterized in the model of Guerrieri, Shimer, and Wright (2010), a model of adverse selection and frictions in the directed (competitive) search theory. CE is defined to maximize the ex-ante utility of all types subject to the frictions in the environment, and is shown to achieve strictly higher welfare compared to equilibrium when equilibrium does not achieve the first best (socially efficient allocation under complete information). Under some conditions, CE even achieves the first best. Sufficient conditions are provided under which the equilibrium is Pareto inefficient. 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 which are monotone in the asset prices