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 in- formation 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.