Endogenous Lemon Markets: Risky Choices and Adverse Selection

(joint with Ran Weksler)

Abstract: We study an adverse-selection model in which the distribution of an asset is affected by unobservable actions of the seller that are performed prior to the trade. We characterise the seller's equilibrium behavior by a risk-seeking property: the seller prefers second-order stochastically dominated distributions. We then show that location-independent riskier distributions lead to lower levels of trade and social welfare. That is, unfavourable conditions for trade in equilibrium are likely in environments in which the seller is able to manipulate the asset distribution. In addition, we study a normal-distribution specification of our model in which, the buyer observes a noisy signal of the asset before trade. We show that, as long as the signal has positive variance conditional on the state, the seller is risk seeking, thereby causing trade to decrease. We also show that our results hold if some sellers can verify the value of their asset and in the case where the buyer is a monopolist.