Honesty and Adverse Selection

There is substantial evidence that generalized trust improves economic outcomes at both the individual and aggregate levels. Furthermore, certain institutions such as educational and religious institutions foster trust, trade, and economic growth. A specific mechanism through which trust might operate is honest communication. We consider the problem of a parent who can enroll her child in an institution which can make her child honest with probability less than one. We assume that whether the child is honest or not is the private information of the child but that institutional membership is observable so that institutions can serve as both imperfect socialization technologies and potentially informative signals of honesty. We consider the two main benchmark adverse selection models in the literature: the screening model and a game-theoretic version of the market for lemons. We provide conditions under which market institutions provide explicit monetary incentives for socialization. When socialization occurs in equilibrium it improves allocative efficiency in the screening model and reduces adverse selection in the market for lemons.