Partial Irreversible Investment and Cyclical Capital Reallocation: the Role of Adverse Selection

There are two facts related to the reallocation of physical assets across plants. In the macro level, capital reallocation, measured as the aggregate sales of used capital, is procyclical. In the micro level, selling used capital is costly. In this paper, I investigate the quantitative contribution of adverse selection in the used capital market towards generating the procyclical capital reallocation, after establishing the consistency with evidences on the selling price of used capital. Embedding adverse selection into an otherwise standard real business cycle model, investment is partial irreversible because of private information in the used capital market. In addition to idiosyncratic technology shocks, plants reallocate their capital because of holding lemons. Plants always sell all of their bad (low quality) capital, since the quality of the used capital is higher than that of the bad capital. A common positive technology shock increases the demand for capital, hence the demand for new capital. The increase in new capital investment causes the increase in bad capital sales in successive periods. Therefore capital reallocation is procyclical. Finally, I find that the adverse selection model explains approximately 75% of the procyclical movement of capital reallocation. However, existing models with fixed irreversibility arising from capital specificity fail to replicate the cyclical movement. JEL Codes: D82; E10; E22; E32.