“A Model of Exchange where Beauty is in the Eye of the Beholder”
MIT 1994 working paper (solo, never submitted)
I explore the search-constrained exchange paradigm where traders differ stochastically in their consumption-valuations of any given good, and all goods are `durable’. Individuals expect to engage in repeat trade before leaving the market. Thus, any good is valued not only for its own flow consumption value but also for its option value for future retrade.
The set of mutually agreeable trades is neatly analogous to the set of even-odds gambles preferred by a risk-loving individual. They are risk-increasing and possibly valuation-decreasing: Trades may result in a lower sum of own-valuations provided the `spread’ increases. Such risky trade stems from the twin properties of a falling demand curve and strict convexity of the value function | where convexity arises because individuals tend to hold onto their more prized possessions longer.
Furthermore, (i) the effect worsens as the search frictions diminish, and (ii) is less than a social planner would prefer. This environment produces a new ex post inefficiency of trade beyond the ex ante inefficiency due to Mortensen (1982). Finally, I show that the risk-increasing effect is muted but still present with positively correlated valuations.