Honesty and Adverse Selection

49 Pages Posted: 22 Apr 2014 Last revised: 6 Sep 2014

See all articles by Michael T. Rauh

Michael T. Rauh

Indiana University - Kelley School of Business - Department of Business Economics & Public Policy

Giulio Seccia

University of Southampton - Division of Economics

Date Written: August 29, 2014

Abstract

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.

Keywords: deception, exchange, honesty, institutions, religion, trade, trust

JEL Classification: D02, D03, D82, Z1

Suggested Citation

Rauh, Michael T. and Seccia, Giulio, Honesty and Adverse Selection (August 29, 2014). Kelley School of Business Research Paper No. 2014-02. Available at SSRN: https://ssrn.com/abstract=2426214 or http://dx.doi.org/10.2139/ssrn.2426214

Michael T. Rauh (Contact Author)

Indiana University - Kelley School of Business - Department of Business Economics & Public Policy ( email )

Bloomington, IN 47405
United States

Giulio Seccia

University of Southampton - Division of Economics ( email )

Southampton, SO17 1BJ
United Kingdom
+44 23 8059 3529 (Phone)
+44 23 8059 3858 (Fax)

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