The Nature of Equilibrium in Markets with Adverse Selection

Abstract

In the presence of adverse selection, how does the nature of the market equilibrium depend on the convention used to set the prices? Using a variant of Akerlof's model of the used car market, we examine the equilibrium of the model under three distinct conventions: (1) an auctioneer sets the price; (2) buyers set the price; (3) sellers set the price. Only in the case of the auctioneer is the equilibrium necessarily characterized by a single price which equates supply and demand. When either buyers or sellers set the price, a distribution of prices may emerge with excess supply at some or all of the prices. The analysis suggests that the allocation of goods in markets where adverse selection is a serious problem may be sensitive to the convention by which prices are set.