Pre-Trade Risky Investments
Posted: 3 Jul 2016
Date Written: June 20, 2016
The paper investigates stochastic private investment prior to trade. We study the incentives of a seller of an asset who can undertake risky investments to change its quality, which is not observable by potential buyers. We find that, even when investing is not efficient, the seller undertakes investment for speculative motives: if the investment's outcome is good she may keep the asset, while if it is not she sells it. Such an investment increases the adverse selection problem, generates an endogenous price dispersion, and it may end up destroying most of the gains from trade. As a result, in some cases, the seller maximizes her rents from trade when the cost of investment to be intermediate instead of too low or too high. Our results apply both when the price is set by a monopsonist and when it set through competition among many buyers. We use our model to the analyze the hold-up problem under stochastic investments.
Keywords: Private Investment, Hold Up Problem, Pre-trade Learning, Price Dispersion
JEL Classification: D82, D83, D42, L15
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