Income Dispersion, Asymmetric Information and Fluctuations in Market Efficiency

Recessions are times when markets function less efficiently. This phenomenon is usually the domain of theories that rely on changes in preferences (demand shocks) or constraints on price-setting (sticky prices). In our simple model of decentralized trade with asymmetric information, income dispersion measures uncertainty about buyer characteristics. Counter-cyclical income dispersion makes the asymmetric information friction stronger in recessions: optimal prices rise and trade volume falls. Unlike preference changes or price-setting constraints, income dispersion is observable. Using income dispersion estimates to quantify the model’s effect, we find that model prices and markups have properties similar to business cycle data. Productivity shocks are strongly amplified: output is more than three times as volatile and more than twice as persistent as our exogenous productivity process. Recessions are times when resources are not put to their most productive uses. Goods take longer to sell (Bils and Kahn 2000), workers are unemployed, and prices do not fall enough to clear markets. Bils (1987) characterizes recessions as times when output prices do not fall as much as marginal cost. Firms’ markups are high, but sales volume is low. Booms are times when unit profits are lower, but sales volume, and thus total profits are high (Rotemberg and Woodford 1999). Recessions are not just declines in productivity, they are also times when markets allocate goods less efficiently: market frictions are counter-cyclical. But in standard business cycle models, markets are always perfectly efficient (Kydland and Prescott 1982). Existing models of counter-cyclical market frictions rely primarily on changes in preferences (demand shocks), or constraints on price setting (sticky prices). Because preferences ∗We thank George Alessandria, Mark Bils, Aubhik Khan, John Leahy, Nick Souleles, Harald Uhlig, Stijn Van Nieuwerburgh, Pierre-Olivier Weill, Michael Woodford and seminar participants at NYU, Philadelphia Fed and Rochester for helpful comments and conversations.