Adverse selection and costly information acquisition in asset markets

Abstract

We develop an asset exchange model with adverse selection and costly information acquisition incentives. A seller of an asset knows the true value of the asset, while a buyer can obtain information about the asset’s quality at a cost. An equilibrium offer is pooling, but a buyer can purchase only good assets after producing the costly information about the asset’s quality. When the probability that the seller holds good assets is above the threshold value, a trade can occur with and without information acquisition, depending on the information acquisition cost, and the trade volume and social welfare are higher in equilibrium without information production than in equilibrium with information production. When the probability of facing good assets is below the threshold value, a trade occurs only after screening the quality of assets, and, hence, the market collapses if the information acquisition cost is sufficiently high. As the information acquisition cost increases, social welfare can increase or decrease depending on the probability of facing good and bad assets.