Capital Reallocation and Adverse Selection

Abstract

We investigate how adverse selection in the used capital market generates procyclical sales of used capital -- capital reallocation. In our model, adverse selection produces a resale discount for used capital. In equilibrium, this endogenous partial irreversibility is more severe in recessions than booms, leading to more reallocation in booms. The distribution of firm size affects the used capital price because aggregate shocks cause firms to exit and enter an investment inaction region, so higher moments of firm size affect the used capital price and investment. We find that neither frictionless models nor models with fixed irreversibility generate procyclical reallocation.