Adverse Selection

Shota Ichihashi∗

ECON 813

1 The Market for Lemons

A seller of an individual good faces n ≥ 2 buyers. The quality of the good is θ and distributed on
[θ, θ] ⊂ R+ with positive density f (θ). Only the seller observes the realized quality.
The value of the good to a buyer is θ, and the value (i.e., reservation value) to the seller is r(θ).
We assume r(θ) = 0, r0 > 0 and r(θ) ≤ θ for all θ ∈ [θ, θ]. Thus, for any given θ it is efficient
to trade the good. If a buyer pays price p and obtains the good, the payoff is θ − p. The seller
obtains payoff p − r(θ) if she sells the good at price p. If trade does not occur, both a buyer and the
seller get zero payoffs. (An equivalent formulation is that the seller obtains price p if trade occurs
and obtains r(θ) if trade does not occur.) This model has interdependent value where a buyer’s
willingness to pay depends on the seller’s type θ.

2 Compete Information Benchmark

Suppose first that the quality is publicly observable to all buyers. We have not defined “equilib-
rium.” However, according to any reasonable notion of equilibrium, we would expect that there
will be an equilibrium price p(θ) ∈ [r(θ), θ] for the good of quality θ such that the trade occurs at
price p(θ). Such an outcome is efficient, because we have assumed θ ≥ r(θ).

3 Unobservable Quality
Suppose now that the quality is unobservable to buyers. In this case, the equilibrium price cannot
depend on the quality. Intuitively, imagine that a seller can choose to sell the good at a high low
price; all sellers would then choose to sell at a high price, so trades cannot occur at two different
prices that depend on the quality. This argument would change if a buyer can use a screening

∗
Various sections of this note draw heavily on notes written by Alexander Wolitzky and “Microeconomic Theory”
by Mas-Colell, Whsinston and Green. The opinions expressed in this article are the author’s own and do not reflect
the views of the Bank of Canada.

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contract; we prohibit the use of screening contract for now. One natural definition of “competitive
equilibrium” is the following:

Definition 1. A (non-trivial) competitive equilibrium (CE) in the market for lemons is a

price p∗ and a non-empty set of types that sell Θ∗ such that

Θ∗ = {θ : r(θ) ≤ p∗ }
p∗ = E[θ|θ ∈ Θ∗ ].

The first condition is the seller’s optimal behavior: The seller sells the good if and only if their
reservation value r(θ) is no greater than market price p∗ . The second condition is that the price
equals the expected quality of the goods on the market. While this condition may remind you
of some underlying game of competition, we leave it for the moment and analyze the efficiency
property of competitive equilibrium.

Proposition 1. No efficient competitive equilibrium exists if and only if r(θ) > E[θ] (i.e., the seller
values the best good more than a buyer’s average value),

Proof. To show the “if” direction, suppose to the contrary that an efficient competitive equilibrium
exists. Then we have Θ∗ = [θ, θ] and p∗ = E[θ]. This implies r(θ) ≤ E[θ], which is a contradiction.
To show the “only if” direction, suppose that r(θ) ≤ E[θ] holds. Then Θ∗ = [θ, θ] and p∗ = E[θ]
now consist of the efficient CE.

Thus, under a mild condition, competitive equilibrium cannot be efficient, even though at every
quality, buyers have a higher willingness to pay for the good than the seller. The problem is that
the price cannot depend on quality. If r(θ) > E[θ], there is no price that a buyer and all types of
the seller are willing to trade.
How do we derive competitive equilibrium? Note that the definition of competitive equilibrium
implies that

p∗ = E[θ|r(θ) ≤ p∗ ].

To graphically identify p∗ that satisfies the above, we can draw the 45-degree line (corresponding
to the left-hand side) and E[θ|r(θ) ≤ p] in the same space. Any point these two line crosses is a
competitive equilibrium. Figure 1 shows the case in which there are 3 competitive equilibria.
Akerlof gives the following example, in which trades do not occur at all in competitive equili-
brum:

Example 1. Suppose θ ∈ U [0, 1] and r(θ) = 2

3 θ. Then E[θ|r(θ) ≤ p∗ ] = E[θ|θ ≤ 3 ∗
2p ] =
min 34 p∗ , 12 . The only p∗ that satisfies p∗ = min 3 ∗ 1 ∗



4 p , 2 is p = 0.

One important observation is that if there are multiple competitive equilibria, they are Pareto-
ranked: A competitive equilibrium that has a higher p∗ Pareto dominates a competitive equilibrium

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 45◦
θ

E[θ]

θ E[θ|r(θ) ≤ p]

p
r(θ) θ r(θ) θ

Figure 1: Three Competitive Equilibria

with a lower p∗ , because the seller is strictly better off at a higher p∗ whereas buyers are indifferent.
Thus, we can think of a lower p∗ equilibrium as a coordination failure: Buyers offer a low price
anticipating that only low-quality goods will be on the market, and it is indeed the case because
the seller anticipates a low price.
The coordination failure suggests that if sellers can move first and offer prices, only the highest-
price competitive equilibrium will be selected. Indeed, if the highest competitive price is p∗ but a
buyer anticipates a lower competitive price, why don’t they offer a price of p∗ − ε to attract high
quality sellers? The following result formalizes this idea, with a caveat that this logic holds only if
the curve E[θ|r(θ) ≤ p] crosses the 45-degree line from above.1

Proposition 2. Consider the game in which buyers simultaneously offer prices and then the seller
accepts or rejects. Let p∗ be the highest competitive equilibrium price. If the curve E[θ|r(θ) ≤ p∗ ]
crosses the 45-degree line from above at p∗ , then in every pure strategy subgame prefect equilibrium
all trades occur at price p∗ and all sellers with r(θ) < p∗ sell.

Proof. Since n ≥ 2, all buyers get payoff 0 in every pure-strategy SPE; otherwise, a buyer would
profitably deviate by offering a price just above the equilibrium price. Suppose trade occurs at
price p < p∗ . Suppose a buyer deviates to offering price p∗ − ε > p for ε small enough such that
E[θ|r(θ) ≤ p∗ − ε] > p∗ − ε (such an ε exists because E[θ|r(θ) ≤ p] crosses the 45-degree line
from above at p∗ ). This offer will be accepted by all sellers with r(θ) ≤ p∗ − ε, so the buyer gets
E[θ|r(θ) ≤ p∗ − ε] − (p∗ − ε) > 0. This is a profitable deviation, so there can be no equilibrium
where trade occurs at price p < p∗ .

1
One version of the condition “crossing from above” is that there is some δ > 0 such that p < E[θ|r(θ) ≤ p] for
every p ∈ (p∗ − δ, p∗ ) and p > E[θ|r(θ) ≤ p] for p ∈ (p∗ , p∗ + δ).

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 The same argument implies that if p∗ > r(θ) then some buyer must actually offer price p∗ in
equilibrium, so all sellers with r(θ) < p∗ must sell. If instead p∗ = r(θ), then there are no sellers
with r(θ) < p∗ so the claim that they sell is vacuous.

Thus we see that the “most efficient” equilibrium is the one that arises when buyers offer prices
and the seller accepts or rejects. Recall also that even this equilibrium can be very inefficient:
Akerlof’s example show that the unique equilibrium has p∗ . Thus Akerlof’s main insight on adverse
selection in the market for lemons continues to hold in the game-theoretic model.