The Efficiency of Centralized and Decentralized Markets for Lemons∗

In markets with adverse selection, when average quality is low and frictions are small decentralized trade produces a greater surplus than predicted by the competitive model: under decentralized trade some high-quality units of the good trade whereas, due to the “lemons problem,” only low-quality units trade in the competitive equilibrium. This suggests a reason why these markets are often decentralized. Remarkably, under some conditions payoffs are competitive as frictions vanish, even though all qualities trade. ∗We gratefully acknowledge Þnancial support from the National Science Foundation, grant SBR9810481, and the Spanish Ministry of Education (DGES), grant PB97-0091. We thank the participants of the 2001 Southwest Economic Theory Conference, the 2001 Decentralization Conference, and the II ESF Exploratory Workshop on Barganing for helpful comments. †Departamento de Economía, Universidad Carlos III de Madrid, 28903 Getafe, Spain ([email protected]). ‡Department of Economics, Hong Kong University of Science and Technology, Kowloon, Hong Kong, and Department of Economics, University of Arizona, Tucson, AZ 85721 ([email protected]).