Date of Original Version

10-2009

Type

Working Paper

Rights Management

All Rights Reserved

Abstract or Description

We propose a model in which firms involved in trading securities overinvest in financial expertise. Intermediaries or traders in the model meet and bargain over a financial asset. As in the bargaining model in Dang (2008), counterparties endogenously decide whether to acquire information, which improves their bargaining position, even though the information has the potential to create adverse selection. We add to this setting the concept of financial expertise" as resources invested to lower the cost of later acquiring information about the value of the assets traded. These investments are made before the parties know about their role in the bargaining game, as proposer or responder, buyer or seller. A prisoner's dilemma arises because investments to lower information acquisition costs improve bargaining outcomes given the other party's information costs, even though the information has no social benefit. These investments lead to breakdowns in trade, or liquidity crises, in response to random but infrequent increases in asset volatility. Persistence in the volatility process can produce contractions and expansions resembling employment cycles for financial experts.

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