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Endogenous Lemon Markets: Risky Choices and Adverse Selection

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  • Avi Lichtig
  • Ran Weksler

Abstract

The severity of adverse selection depends, to a great extent, on the underlying distribution of the asset. This distribution is commonly modeled as exogenous; however, in many real-world applications, it is determined endogenously. A natural question in this context is whether one can predict the severity of the adverse selection problem in such environments. In this paper, we study a bilateral trade model in which the distribution of the asset is affected by pre-trade unobservable actions of the seller. Analyzing general trade mechanisms, we show that the seller’s actions are characterized by a risk-seeking disposition. In addition, we show that (location-independent) riskier underlying distributions of the asset induce lower social welfare. That is, “lemon markets” arise endogenously in these environments.

Suggested Citation

  • Avi Lichtig & Ran Weksler, 2023. "Endogenous Lemon Markets: Risky Choices and Adverse Selection," Journal of the European Economic Association, European Economic Association, vol. 21(2), pages 413-454.
    • Handle: RePEc:oup:jeurec:v:21:y:2023:i:2:p:413-454.
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    File URL: http://hdl.handle.net/10.1093/jeea/jvac041
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    JEL classification:

    • C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • L15 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Information and Product Quality

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