Endogenous Lemons Markets and Information Cycles

Abstract

This article develops a dynamic stochastic general equilibrium model in which information on capital quality is asymmetric and the degree of information asymmetry varies endogenously with the state of the economy, amplifying the shocks. Firms hold capital and borrow to cover operating expenses. Production is subject to idiosyncratic shocks. When a firm's realized revenue is not enough to cover its debt obligation, the firm must liquidate capital in a market that is subject to the lemons problem. During production, some of the firms' capital depreciates, becoming ``lemons''. Firms initially have no information on which units of their capital have depreciated, but they can acquire private information on the quality of their own capital at a cost, which allows them to select low-quality capital to sell during liquidation. Although private information acquisition can be individually beneficial, it generates the lemons problem, decreasing market liquidity and distorting economic allocations. Adverse shocks trigger additional private information acquisition, exacerbating the lemons problem. The model can account for the business cycle patterns in the U.S., and in particular the sizable fluctuations of capital reallocation.

Keywords: endogenous lemons market, information acquisition, liquidity, capital reallocation, business cycles

JEL Classification: D82, E22, E24, E32, E44