Equilibrium and Adverse Selection
A common characteristic of a large class of markets is that one side of the market is more informed than the other about the properties of one of the goods being traded. In some instances, this presents no serious problem. If the informed agents deal on a regular basis with the less-informed agents (for example, local grocers, barbers), there may be little incentive for the informed agents to take advantage of their superior information. In other cases, the problem may be avoided if it is profitable for specialists (or some government agency) to provide the information at a relatively low cost (for example, credit agencies, Consumer Reports). Frequently, however, these kinds of market responses provide at best a partial reduction in the informational asymmetry. There may still be substantial benefits to the less-informed agents from acquiring more information. How the market will respond under these circumstances has been the focus of much recent research. Most of the attention, however, has been directed at examining the possibility that a signalling convention will emerge. The essential idea is that sellers of high quality products may choose contracts or invest in observable characteristics which distinguish their products from those of lower quality. Although I believe that signalling is an important and pervasive phenomenon, the conditions necessary for effective signalling to emerge may not always be satisfied. It is important, therefore, that we understand how the allocation of goods is affected in the absence of signalling, when the only variable that agents may use to distinguish quality is the price. This paper provides an overview of some of my recent research on this question. My investigation begins with a welfare analysis of the Walrasian equilibrium. Specifically, the question is whether or not it is necessarily desirable for trade to take place at a price which clears the market. My analysis indicates that it is not. Under some conditions, it may be possible to make every agent in the market better off simply by raising the price. Besides generating some obvious policy implications, this result also suggests that the Walrasian equilibrium may not always be the appropriate equilibrium concept for this model. In a market with homogeneous goods, it is generally argued that independently of how the prices are set, as long as there is a large number of buyers and sellers, competitive pressures will force the price toward a stable Walrasian equilibrium. When an adverse selection problem appears, however, the possibility that some buyers may prefer a price higher than the one which clears the market casts some doubt as to whether such pressures will still be present. It is no longer obvious that the market will clear or even that all trade will take place at a single price. These points can be conveniently illustrated using George Akerlof's model of the used car market. There is a set of cars of varying quality q distributed over an interval [ql, q2] with densityf (q). Each agent in the economy has an identical utility function u(c, q; t) = c + tq where c is consumption of other goods, q is the quality of car he consumes, and t is a parameter equal to his marginal rate of substitution of car quality for consumption. (If an agent does not consume a car, q may be set equal to zero.) The set of agents can be divided into two subsets, those that initially own exactly one car and those that own none. Each owner has the same utility parameter, t = 1; for the nonowners, however, t is distributed continuously over some interval [tl, t2] with density h(t). As long as each owner can directly identify the quality of his own car, the supply curve will have the usual positive slope. A utility maximizing owner with a car of quality q will sell at price p if and only if q _ p. As the price rises, therefore, more cars will be supplied. If *Department of economics, University of Wisconsin. This research was supported by the National Science Foundation under Grant SOC-77-08568.
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