Adverse Selection

Economics 302 - Microeconomic Theory II: Strategic Behavior

Instructor: Songzi Du
compiled by Shih En Lu
Simon Fraser University

March 18, 2015

ECON 302 (SFU)

Lecture 10

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Most Important Things to Learn Today

Know what adverse selection is

Know how adverse selection can make a market unravel

ECON 302 (SFU)

Lecture 10

March 18, 2015

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Hidden Characteristic
Last week, we studied hidden action: what happens when one side of
the market doesnt observe what the other side does.
Hidden action can lead to moral hazard: informed side might engage
in bad behaviour.
This week, we study hidden characteristics: what happens when
one side of the market lacks payoff information (such as quality of
the good and the valuation of the customer), while the other side of
the market possess such information (seller knows the quality of the
good that he sells, customer knows his valuation for the good that he
wants to buy).
Private information possessed by a player is called the type of the
player.
Todays example: buyer doesnt know the quality of a car, and
therefore doesnt know his utility from buying the car.
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Adverse Selection

Hidden characteristic can lead to adverse selection: the market

attracts exactly the agents on the informed side that are bad for the
uninformed side.
Todays example: owners of bad cars are the ones that want to sell
the most.
We will show that adverse selection can make some markets fail
completely and disappear!

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Used Car Market

For simplicity, suppose the sellers and the buyers are both risk-neutral.
Good cars are worth $10,000 to buyers and $7,000 to sellers.
Bad cars are worth $3,000 to buyers and $1,000 to sellers.
Half the cars are good and half are bad.
What is the efficient allocation of cars?

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Used Car Market: Complete Information

Good cars are worth $10,000 to buyers and $7,000 to sellers.

Bad cars are worth $3,000 to buyers and $1,000 to sellers.
Half the cars are good and half are bad.
Suppose both sides observe car quality.
What happens? At what prices?

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Used Car Market: Incomplete, but Symmetric Information

Good cars are worth $10,000 to buyers and $7,000 to sellers.

Bad cars are worth $3,000 to buyers and $1,000 to sellers.
Half the cars are good and half are bad.
Suppose neither side observes car quality.
What happens? At what price?

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Used Car Market: Asymmetric Information (I)

Alternative name: lemons market (Akerlof, 1970).

Good cars are worth $10,000 to buyers and $7,000 to sellers.
Bad cars are worth $3,000 to buyers and $1,000 to sellers.
Half the cars are good and half are bad.
Suppose only sellers observe car quality (because the seller owns the
car).
If both good and bad cars are on the market, how much are buyers
willing to pay?
What would sellers do at that price?

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Used Car Market: Asymmetric Information (II)

Buyers are unwilling to pay a lot because some cars are of low quality.
But then sellers with good cars are unwilling to sell. So only sellers
with bad cars are left.
This is adverse selection: the market attracts exactly the sellers that
are bad for the buyers.
As a result, the market for good cars unravels and disappears.
Loss of efficiency: the surplus from trading good cars vanishes.

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Conclusion

When buyers dont know the quality of a product, they might not be
willing to pay enough to cover high-quality sellers costs.
High-quality sellers will then exit the market, reducing the average
product quality and further decreasing buyers willingness to pay.
Vicious cycle leads to low quality.
If buyers value for low quality goods is too low, market could even
disappear completely.
Ways around problem: signaling (warrantees), reputation, regulation,
liability laws, etc.

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Used Car Game: seller proposes

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Used Car Game: buyer proposes

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