Adverse Selection

Game Theory · Axiom Academy

Understanding how hidden information before contracting leads to market failure 1. The Adverse Selection Problem The fundamental issue arises when: Sellers know the true quality of their product (high or low) Buyers cannot observe quality before purchase All products trade at the same price (pooling equilibrium) This creates a strategic environment where buyers must form beliefs about average quality, but their beliefs become self-fulfilling. 2. Akerlof's "Market for Lemons" Good cars ("Peaches"): Worth 10,000 to sellers, 12,000 to buyers Bad cars ("Lemons"): Worth 4,000 to sellers, 6,000 to buyers Buyers believe average quality, willing to pay: 0.5( 12,000) + 0.5( 6,000) = 9,000 At 9,000, owners of peaches (worth 10,000) refuse to sell Only lemons remain on the market Buyers realize only lemons are for sale, offer maximum 6,000 Market functions only for low-quality goods 3. How Bad Types Drive Out Good The mechanism behind market unraveling is a form of Gresham's Law applied to information: Let quality be distributed uniformly on [0, 1]. Seller values quality at q, buyer values it at 1.5q. If buyers believe average quality is q̄, they offer price P = 1.5q̄. Sellers with q > P/1 = 1.5q̄/1 will exit. This means only sellers with q ≤ 1.5q̄ remain. But then average quality becomes q̄ = 0.75q̄, not q̄. The only consistent equilibrium is q̄ = 0! 4. Market Unraveling Animation

This is the written version of the interactive lesson above. See the full Game Theory course.