Unobservable Investments, Trade Efficiency and Search Frictions

Abstract

Market participants can invest to increase their gains from trade before searching for partners. The entrants type distribution and trade efficiency are jointly determined and correlated. This paper explores a random search model of ex ante investments and trade efficiency, assuming that the investment amount remains the investor s private information. We show that the ex ante payoffs are equivalent to the equilibrium payoffs when investments are observable. In the unique steady state equilibrium, non-degenerate investment distribution and price distribution emerge simultaneously with ex-ante identical agents. In the basic model, where investing agents have no bargaining power, the extra investments fail to improve social welfare even when the search friction vanishes and the investments become efficient due to the mismatches caused by unobservability. Allocating positive bargaining power to investors alleviates the mismatch problem and improves social welfare.