DECENTRALIZED TRADE MITIGATES THE LEMONS PROBLEM*

Abstract

In markets with adverse selection, only low‐quality units trade in the competitive equilibrium when the average quality of the good held by sellers is low. We show that under decentralized trade, however, both high‐ and low‐quality units trade, although with delay. Moreover, when frictions are small, the surplus realized is greater than the (static) competitive surplus. Thus, decentralized trade mitigates the lemons problem. Remarkably, payoffs are competitive as frictions vanish, even though both high‐ and low‐quality units continue to trade, and there is trade at several prices.