Adverse Selection

Asymmetric information gives rise to a difficult problem in bargaining. Suppose a person accepts your proposed transaction price. Does the very fact that they said yes mean that you won’t actually like the deal?

Used cars provide a canonical example. Sellers have private information about how well the car has been maintained and thus how valuable it is. If the seller has a pristine car, they will not let it go at a low price. But this implies that offering a low price induces only low quality types to sell—perhaps such great clunkers they would rather not make the transaction at all. This is adverse selection. The proposer wants to screen for quality but ultimately can only exclude the high quality goods from the transaction.

Adverse selection concerns are present in many other marketplaces, including insurance sales and houses. This lecture provides a crash course on the subject.

Takeaway Points

  1. Buyers are only willing to purchase at a price that reflects the average value of the types that sell to them. But if there is an enormous difference between how a high quality seller’s reservation value and the buyer’s value for a low quality good, the high quality seller will want to leave the market.
  2. Asymmetric information leads to an inefficiency: both the buyer and the high quality seller would benefit from reaching an agreement, but the presence of low quality sellers prevents that from happening.
  3. In practice, the market takes many actions to try to mitigate the inefficiency. Lemon laws allow buyers to return bad cars within a set time frame of purchase. Dealerships can establish a reputation for honest assessments of quality, sacrificing a short-term gain for a longer-term stream of customers. Expert appraisers visit houses to make sure that listing prices reflect the true value.
  4. Another solution to the market problem is to remove the market altogether. This is one the motivators behind universal health care programs.

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