Endogenous Lemon Markets: Risky Choices and Adverse Selection

The severity of adverse selection depends, to a great extent, on the underlying distribution of the asset. This distribution is commonly modeled as exogenous; however, in many real-world applications, it is determined endogenously. A natural question in this context is whether one can predict the severity of the adverse selection problem in such environments. In this paper, we study a bilateral trade model in which the distribution of the asset is affected by pre-trade unobservable actions of the seller. Analyzing general trade mechanisms, we show that the seller’s actions are characterized by a risk-seeking disposition. In addition, we show that (location-independent) riskier underlying distributions of the asset induce lower social welfare. That is, “lemon markets” arise endogenously in these environments.