Endogenous Entry in Markets with Adverse Selection

Abstract

Since Akerlof's (1970) seminal paper the existence of adverse selection due to asymmetric information about quality is well-understood. Yet two questions remain. First, given the negative implications for trading and welfare, how do such markets come into existence? And second, why have many studies failed to find direct or indirect evidence of adverse selection? In addressing the first question directly we shed some light on the second. We consider a market in which firms make an observable investment that generates products of a quality that becomes known only to the firm. Entry has the tendency to lower prices, which may lead to adverse selection. The implied price collapse limits the amount of entry so that high prices are supported in the market equilibrium, which results in above normal profits. While contributing to our understanding of markets with asymmetric information and ad- verse selection, the model also provides insight into the question of why markets with adverse selection are empirically hard to identify. The analysis suggests that rather than observing the canonical market collapse, such markets are instead characterized by less entry than would be empirically predicted and above normal profits even in markets with low measures of concentration.