Dynamic Markets for Lemons: Performance, Liquidity, and Policy Intervention

Even though adverse selection pervades markets for real goods and financial assets, equilibrium in such markets is not well understood. What are the properties of equilibrium in dynamic markets for lemons? What determines the liquidity of a good? Which market structures perform better, decentralized ones, in which trade is bilateral and prices are negotiated, or centralized ones, in which trade is multilateral and agents are price-takers? Is there a role for government intervention? We show that when the horizon is finite and frictions are small, decentralized markets are more liquid and perform better than centralized markets. Moreover, the surplus realized is above the static competitive surplus, and decreases as the horizon grows larger, approaching the static competitive surplus as the horizon becomes infinite even if frictions are non-negligible. Subsidies on low quality or taxes on high quality raise surplus.