A Note on Adverse Selection and Bounded Rationality

There is accumulating evidence that some consumers are behavioral in the sense that they may make suboptimal decisions. This paper investigates adverse selection with general types of such behavioral biases. In our model, some buyers (i.e., consumers) may take actions that do not necessary optimize own payoffs, which encompass virtually any type of biases including subjective probability,framing, model misspecification, random errors, and inferential naivety. We focus on a situation in which there exists severe adverse selection where only no-trade outcome is possible under rational agents. We show that the no-trade theorem remains to hold without imposing any additional assumption on buyers' behavior. That is, if there is any trade under a mechanism which is incentive compatible for sellers, then the expected payoff from the trade is negative (i.e., ex ante individual rationality constraint is violated) for some type of buyers. Our result sheds light on a new trade-off between social surplus and payoff losses of boundedly-rational buyers.