Optimal policy in lemon markets with flexible information acquisition

I examine the impact of government interventions in lemon markets where buyers can acquire information about asset returns. In markets where the cost of information is high, direct asset purchases may cause welfare losses by crowding out private asset demand. As an alternative policy to overcome the issue, I study optimal loss insurance, recognizing that an insurance policy may also cause welfare losses, possibly because of moral hazard or taxation. I find that an optimal policy design requires careful consideration of two factors: the cost of information and the endogenous effect of asset price on asset returns. When such an endogenous effect is high, the optimal insurance can be a hump-shaped function of a default rate. When the information cost is high, the optimal insurance provides greater protection to both the best and worst states, thereby increasing an upside risk and decreasing a downside risk.