Endogenous Lemon Markets: Risky Choices and Adverse Selection

Adverse selection severity depends on the asset’s distribution, which can be endogenously determined in real-world applications. This study examines a bilateral trade model where the seller’s pre-trade actions impact the asset’s distribution. Findings reveal that the seller exhibits risk-seeking behavior and riskier underlying distributions result in lower social welfare. Consequently, “lemon markets” emerge organically in these environments.

Image courtesy of interviewee. December 19, 2023

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