Scandinavian Working Papers in Economics

Working Papers,
Lund University, Department of Economics

No 2021:11: Cycling and Categorical Learning in Decentralized Adverse Selection Economies

Philippe Jehiel () and Erik Mohlin ()
Additional contact information
Philippe Jehiel: Paris School of Economics, Postal: 48 boulevard Jourdan, 75014 Paris, France.
Erik Mohlin: Department of Economics, Lund University, Postal: Department of Economics, School of Economics and Management, Lund University, Box 7082, S-220 07 Lund, Sweden

Abstract: We study learning in a decentralized pairwise adverse selection economy, where buyers have access to the quality of traded goods but not to the quality of non- traded goods. Buyers categorize ask prices in order to predict quality as a function of ask price. The categorization is endogenously determined so that outcomes that are observed more often are categorized more finely, and within each category beliefs reflect the empirical average. This leads buyers to have a very fine understanding of the relationship between qualities and ask prices for prices below the current market price, but only a coarse understanding above that price. We find that this induces a price cycle involving the Nash equilibrium price, and one or more higher prices.

Keywords: Adverse selection; Bounded rationality; Categorization; Learning; Model misspecification; OTC markets

JEL-codes: C70; C73; D82; D83; D91

56 pages, September 2, 2021

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