Estimates of expected costs and benefits from a contract tend to be unbiased if each party shares fully all the information available before reaching a final agreement. Frequently, however, one side may conceal or distort information to strengthen its bargaining position. This can verge on fraud. For example, someone who already took a course might sell you an old text, knowing that the instructor is requiring use of a newer edition.
Adverse selection occurs when one bargaining party ultimately suffers unexpected disadvantages because the other party conceals information prior to a contract.
You may have heard of pensioners who have been swindled of their life savings by con artists. Such confidence games as they are called, are extreme examples of the problem of adverse selection. Operators of fly-by-night businesses often guarantee faulty goods, knowing that the guarantees are worthless. Some deadbeats try to build up records of paying small bills so that they can secure credit that will allow them to run up indebtedness that they never intend to pay.
The problem of adverse selection is a major reason for laws that forbid fraud. Consequently, a common rule of law is that ambiguity in a contract will be interpreted against the party who wrote the agreement.
Used car markets exemplify classic problems posed by asymmetric information.5 Consider a simple model of information in used car markets. Suppose sellers with perfect information sell cars to one-time buyers with limited information. Buyers may know the proportion of lemons and good cars, but cannot distinguish lemons from cream puffs. Adverse selection allows sellers of lemons to misrepresent their cars. Because buyers cannot ascertain quality in this model, both lemons and good cars sell for the same price!
Lemons will be overpriced while cream puffs are undervalued. But owners of good cars will not want to sell at these reduced prices, while owners of lemons are delighted to sell. The result of this oversimplified model is that only lemons are offered for sale, or a market fails to exist. The lesson here is that when quality is unknown to the buyer, equilibrium prices fall and fewer transactions occur, even though further gains from exchange could be realized. However, since markets for used cars thrive in most communities, what has this model ignored?
The answer is that alternative mechanisms have developed around this market to partially resolve problems of asymmetric information. Drivers who fear buying lemons in the open market may buy only from close friends, who presumably hope to maintain amicable relationships. Publications such as Consumer Reports provide data on quality and frequency of repair for most vehicles. Firms such as Lemon-Aide emerge: experts who will, for roughly $75, assess quality and look for hidden defects for potential buyers. Guarantees also help, but only if they are enforceable.
Federal law now requires mileage certificates on all cars, and some states have enacted defect disclosure laws intended to protect consumers from unscrupulous dealers. Some economists argue, however, that since most auto dealers have continuing relationships with their communities, such laws may be unnecessary.