CFDP 1573

Extreme Adverse Selection, Competitive Pricing, and Market Breakdown

Author(s): 

Publication Date: July 2006

Pages: 46

Abstract: 

Extreme adverse selection arises when private information has unbounded support, and market breakdown occurs when no trade is the only equilibrium outcome. We study extreme adverse selection via the limit behavior of a financial market as the support of private information converges to an unbounded support. A necessary and sufficient condition for market breakdown is obtained. If the condition fails, then there exists competitive market behavior that converges to positive levels of trade whenever it is first best to have trade. When the condition fails, no feasible (competitive or not) market behavior converges to positive levels of trade.

Keywords: 

Adverse selection, Market breakdown, Separation, Competitive pricing

JEL Classification Codes:  D40, D82, D83, G12, G14