Inverse Adverse Selection: The Market for Gems

Abstract

This paper studies markets plagued with asymmetric information on the quality of traded goods. In Akerlof’s setting, sellers are better informed than buyers. In contrast, we examine cases where buyers are better informed than sellers. This creates an inverse adverse selection problem: The market tends to disappear from the bottom rather than from the top. In contrast to the traditional model, it is the high-value goods (gems) that are traded on the market, rather than the low-value goods (lemons). We investigate the consequences of this inverse adverse selection and its potential solutions. The uninformed buyer in a traditional market for lemons experiences the quality of the good he purchased; instead, the uninformed seller may never know the quality of the good that he sold. This renders the conventional legal and contractual solutions to the lemons problem often ineffective in the gems case. We further explore the theoretical and practical appeal of market, contractual, and legal solutions. Our results show that auctions (competition among many informed buyers) provide a solution to the inverse adverse selection problem.

Keywords: Lemons, Gems, Adverse Selection, Asymmetric Information, Auction

JEL Classification: D44, D82, D86, K12