PowerPoint Slides © Michael R. Ward, UTA 2014
Econ 5313
“The Market For Lemons”
Baby Model
Looking for a used car
The Buyer cannot tell “lemons” from “cherries”
But Seller knows
Actual range of values are from $2,000 to $4,000 with
each price equally likely
• Average or expected value is $3,000. If the buyer offers
this, he expects to do OK ½ the time (value > $3,000) and
not ½ the time (value < $3,000)
Econ 5313
“The Market For Lemons”
• Distribution from
$2,000 to $4,000
• Each is equally likely
• Offer the EV =
• Expect to do come
out ahead half of
the time and not
half of the time
Econ 5313
“The Market For Lemons”
• But will all the cars
be offered for sale?
• Will sellers with car
values > $3,000
actually sell?
Econ 5313
“The Market For Lemons”
• But will all the cars
be offered for sale?
• Will sellers with car
values > $3,000
actually sell?
• Red portion is
• Green portion is
• Relevant
distribution from
$2,000 to $3,000
• Offer the EV =
Econ 5313
“The Market For Lemons”
• Offer $2,500
• Problem?
• Now cars worth >
$2,500 are withheld
• What is the
equilibrium of this
• Price = $2,000
• The set of goods
being offered are
Econ 5313
“The Market For Lemons”
• The problem is “Asymmetric Information,” not just
• If seller and buyer are equally ignorant of the true value
what would the outcome be?
• At first stage, buyer offers $3,000
• Seller knows car could be worth more or less but does not
• On average he would be OK so he accepts
• Symmetric ignorance would not be a problem here
Econ 5313
Adverse Selection in Product Markets
• Typology of products:
• Search Goods – product quality observable before purchase
• Experience Goods - product quality only observable with use
• Credence Goods - product quality may never be revealed
• Products have a mixture of both search and experience
• As an economy matures, there is greater demand for quality
• Usually these are experience characteristics that result in adverse
selection problems
• How do you sell products with important high-quality
characteristics when the quality is not directly observable?
Econ 5313
“Hostage Taking” (& Offering)
• Solution must involve keeping the transaction open until
information becomes symmetric enough
• Often requires the seller to “Offer a Hostage”
• Example Two city-states ganging up on a third
• Business Context – Devise a contract in which the sellers
of low quality products suffer disproportionate harm
• Signaling Examples:
Bonding – e.g. home repair by tradesmen
Warranties/Guarantees – cheaper if better quality
Reputation – e.g. professional services, lawyers
Advertising – “buy” a reputation to lose
Econ 5313
• Adverse selection is fundamental in the insurance market
• The demand for insurance comes from consumers who do
not like risk
• We model risk as a random variable with a payment
attached to each outcome
• A risk-neutral consumer values a lottery at its expected value
• A risk-averse consumer values it at less than its expected value
• Consider a coin flip
• The payoff from heads is $100 and from tails is $0
• A risk-neutral consumer would value it at $50.
• A risk-adverse consumer would value the lottery at $40
• Insurance moves “risk” from the risk adverse consumer
(lower value) to a risk neutral insurer (high value)
Econ 5313
• So insurance is a wealth creating transaction, except that
it moves a “bad” from someone who doesn’t want it (risk
averse consumer) to someone who willing to accept the
risk for a fee (insurance company)
• Numerical example: Rachel owns a bicycle valued at $100
• The bike has a possibility of being stolen, meaning Rachel’s
payoffs are lose $100 if it’s stolen, lose $0 if it isn’t
• If the probability of theft is 20%, then the expected cost of
the lottery is 0.2×$100 = $20
• An insurance policy for the value of the bike costs $25,
eliminating the risk of owning a bike
Econ 5313
• If she is risk averse enough she buys the insurance
• Say she values the insurance at $30
• Both insurance company and Rachel are better off with
this policy
• The company earns $5 (=$25-$20), on average, and Rachel
can stop worrying about bike theft
• She “pays” the insurance company $25 each year so she
doesn’t have to face the risk of bike theft and has surplus
of $5 (=$30-$25)
Econ 5313
• Note that the insurance company never actually earns $5
on any given transaction
• Either the company loses $75 if the bike is stolen, or earns
$25 if it is not
• The expected value of offering insurance, though, is $5
$5 = 0.2 × ($-75) + 0.8 × $25
• Because they write so many offsetting policies, insurers
actually face little overall risk and so are risk neutral
Econ 5313
• To explain on adverse selection, we modify the bike
• Now suppose that there are two equally sized risk-adverse
consumer groups:
• Group 1 with a probability of theft of 0.2
• Group 2 with a probability of theft of 0.4
• What happens when you try to sell insurance at a price of
$35 (to average across groups)?
• Who is willing to pay $35?
• Because only high-risk consumers would be willing to pay
the higher price, the company would consistently be
paying out claims
Econ 5313
• Anticipate adverse selection and protect yourself against it
• This means anticipate that only the high-risk types will
buy, so price the insurance at $45
• This also means that the low-risk types may go un-served
in this insurance market
• Analogous to withholding the more valuable cars
• Example For health care insurance, which is the largest
group among the uninsured?
• Healthy 20-somethings because insurance premiums are not
worth it
• We had to pass a law to force them to buy
Econ 5313
Futures Markets
• One main function of the financial industry is allocating
risk; moving risk from lower- to higher-valued uses
• How do futures contract re-allocate risk?
• Farmers face two forms of risk:
Output risk – under his control
Price risk – out of his control
• Most of a farmer’s expected Fall harvest can be sold in the
Spring before he plants
• Deals with price risk
• Why are buyers of commodity futures contracts better
able to absorb the risk?
Econ 5313
• In financial markets, adverse selection becomes a problem
when the owners of a company want to sell shares to the
public but know more information about the prospects of
the company than potential investors
• Potential investors should anticipate that companies with
poor prospects are most likely to sell to the public
• For example, small initial public offerings (IPOs) of less
than $100 million lose money, on average, whereas large
IPOs have “normal” returns
• The winner’s curse of common-value auctions is also a
type of adverse selection (later)
Econ 5313
Partial Insurance
• In the bicycle example, if the insurance company sells
policies at $45, low-risk consumers are un-served
• But these consumers would be willing to pay $25, which is
still more than the cost to the company of insuring the
bike, $20
• Adverse selection presents many potentially profitable
and unconsummated wealth-creating transactions
• Can you devise a way to serve them without falling victim
to adverse selection?
• Using screening or signaling can help overcome the
adverse selection problem so that low-risk individuals can
be transacted with profitably
Econ 5313
• One solution to adverse selection is to gather information
to distinguish high-risk from low-risk consumers
• Screening is an effort by the less-informed party to induce
of consumers to reveal their types
• But this can be difficult and costly to do
• Privacy and anti-discrimination laws frequently prevent
insurance agencies, and other companies, from gathering
or using certain information (race, gender, credit scores)
• Sometimes indirect methods can be used
• Information may be gathered indirectly by offering
consumers a menu of choices, and consumers reveal
information about their risks by the choices they make
Econ 5313
• Screening is frequently used in the insurance market
• Example High-risk individuals prefer full insurance at $45,
to partial insurance (for instance receiving only $50 if your
bike is stolen) at $15
• For a successful screen, it must not be profitable for the
high-risk consumers to mimic the choice of the low-risk
• Screening reduces the information asymmetry and so may
allow the consummation of previously unconsummated
wealth-creating transactions
Econ 5313
• Owners of good cars are analogous to low-risk insurance
consumers – they are unable to transact
• How can this unconsummated wealth-creating transaction
be consummated?
• In other words, how can you design a screen for those
who want to buy a “cherry,” and not a “lemon?”
• One option is for the buyer to get a mechanic’s opinion
• The cost of “an expert opinion” may be much less than the
cost of a lemon
• Also, the lemons owner might balk and such a request
Econ 5313
Marriage Screens
• Louisiana offers a choice between two marriage contracts:
a covenant contract which makes divorce expensive; and a
regular contract which makes divorce relatively cheap
• How does Louisiana marriage law function as a screen?
• What is adverse selection problem in marriage?
• Recently, Mexico has proposed a different type of
marriage that expires after three years.
• What adverse selection problems might you foresee?
Econ 5313
Engagement Ring Screens
• Diamond engagement rings were not common 100 years
• “Progressive” reforms removed law suits for damages
from jilting the bride at the altar
• What damages?
• How does demanding the ring solve the problem?
• Hint Some brides and grooms lived as wives and husbands
prior to marriage.
• Hint What do future suitors infer about the would-be
spouses who had been jilted?
Econ 5313
Incentive Compensation as a Screen
• Some sales people are hard workers and will sell 100 units
per week, and others are lazy workers, who will sell only
50 units per week
• Asymmetric information means only workers known if
they are lazy or hard working
• Because both types of employee will accept an offer of
$800/week, you will attract a mix of lazy and hard workers
• How does commission fix this?
• Incentive pay ($10 per sale) solves the problem: hard
workers earn $1000 and lazy workers will reject the offer
(they expect to earn only $500)
Econ 5313
Incentive Compensation as a Screen
• Incentive pay imposes risk on the workers – some sales
factors are out of their control
• Have to pay risk averse worker to accept this risk
• Another screen with less risk: offer a base salary of $500
plus $10 per sale for every unit above 50 sales
Econ 5313
• Another solution to adverse selection is to credibly reveal
information to distinguish which group they are in
• Signaling describes the efforts of the more informed party
(consumers) to reveal information about themselves to
the less informed party (the insurance company)
• A successful signal is one that bad types will not mimic
• How can a screen be used as a signal?
• Low-risk consumers could offer to buy high deductible
insurance, good employees could offer to work on
commission, and cherry cars sellers could include a
warranty with the purchase
Econ 5313
Education as a Screen
• Some of the value of education is in its signaling value
• Students can signal employers that they’re hardworking,
quick-learning, dedicated, etc. by spending the time and
money necessary to pursue an education
• Could this work even if the education does not make them
any more productive?
• We hope it does make you more productive though
• (There is evidence for both the signaling and the
productivity theories)
Econ 5313
Car Selling
• Owners of good cars are analogous to low-risk insurance
consumers or high quality students
• How can owners of “cherries” sell their cars for a price
reflecting their quality?
• What signals do car owners send to distinguish a cherry
from a lemon?
• One option is to offer a money-back guarantee
• The cherry owner knows that it won’t be returned so the
guarantee costs little
• The lemon owner knows that it could be returned so the
guarantee is costly
Econ 5313
Brand Advertising as a Signal
• Firms brand and advertise products to signal quality to
• As a result, most consumers are now willing to pay more
for branded and advertised goods
• Low-quality firms won’t find it profitable to advertise
because once consumers use the product and notice the
difference, they will switch brands and the firm will have
wasted money on the advertising
• Note that some states prohibit advertising, e.g., for
financial advisors, that would serve as a signal of quality
• Example Pearl Vision
Econ 5313
Dressing Up as a Signal
• Dress appropriately to signal quality to potential
• As a result, employers infer you are a serious job
• Low-quality job candidates know that they are not likely to
get much use out of a business suit
• “I’d never want to join a club that would have someone like me as
a member” – Groucho Marx
• Also goes for knowing appropriate business etiquette
• Preening and dressing for a first date is also a form of
Econ 5313
Other Examples
Business Cards
• How much do you know about business cards?
• American Psycho: Business Card Scene
• Of course, both the Interviewer and the interviewee are
sending signals at job interviews
• Strange Wilderness: Hiring Scene
Econ 5313
• Sellers have better information than buyers about the
quality of goods being offered for sale
• Anticipating adverse selection leads buyers to offer less,
which makes sellers less willing to sell high quality goods
• Consummated transactions are more likely to leave buyers
disappointed in the quality (“lemons”)
• How does eBay try to solve this problem?
• By providing:
• Escrow services
• Fraud insurance
• Seller ratings – provided by past buyers
Econ 5313
Pre-hire Training
• South Carolina manufacturing firm hiring new employees
• Requires 24 unpaid classroom hours over 8 days in 4 week period
• Final step before full-time employment
• If candidate is tardy, he/she is sent home and not allowed to
• Results:
• Of 30 people, two candidates are sent home
• Only ten of the 1,300 workers hired under the program have had
significant attendance issues
• Program reduced the rate of bad hires from about eight percent
to less than one percent
• Signal or Screen?
Econ 5313
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Econ 5313
Main Points
• Asymmetric Information introduces more problems for
voluntary exchange than mere uncertainty
• One aspect of asymmetric information is adverse selection
in which primarily low values select into transactions
• This means that some assets are stuck in low value uses
which means … a potential profit opportunity
• Realize these profits be devising ways to screen or signal
• Adverse selection is a major problem in: financial markets,
employment markets, product markets, mating markets,
and …

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