Overconfidence in the Markets for Lemons
We extend Akerlof (1970)â€™s â€œMarket for Lemonsâ€ by assuming that some buyers are overconfident. Buyers in our model receive a noisy signal about the quality of the good that is on display for sale. Overconfident buyers do not update according to Bayesâ€™ rule but take the noisy signal at face value. We show that the presence of overconfident buyers can stabilize the market outcome by preventing total adverse selection. This stabilization, however, comes at a cost: rational buyers are crowded out of the market.
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