Adverse Selection, Seller Effort, and Selection Bias

Abstract

1. IntroductionResearchers use several approaches to identify adverse selection.1 Genesove (1993) tests the proposition that, in a lemons market, prices inversely relate with observable seller characteristics that correlate with seller incentives to select goods adversely. Genesove examines the proposition in used automobile auctions. Chezum and Wimmer (1997) examine the proposition in thoroughbred racehorse markets, arguing that sellers with a high propensity to race horses should receive, on average, lower prices. Both Genesove (1993) and Chezum and Wimmer (1997) use data limited to market transactions. Wimmer and Chezum (2003) model adverse selection as a case of Heckman's (1979) sample selection bias and examine the correlation between errors in participation and price equations to study how third party certification could alleviate the effect of adverse selection in thoroughbred auctions.2In this paper, we extend the work of Genesove (1993) and Chezum and Wimmer (1997) and Wimmer and Chezum (2003) by characterizing adverse selection as a sample selection problem in a setting in which sellers possess (1) an informational advantage over buyers and (2) characteristics that correlate with both seller incentives to select goods adversely and the quality of goods produced. In such a setting, the relationship between prices and seller characteristics proves ambiguous, and researchers cannot easily disentangle adverse selection from quality effects. We show that Heckman's sample selection framework disentangles the correlation between a seller's characteristic and the effect of the selection decision on price from the correlation between a seller's characteristic and the quality of goods produced by a seller.The notion that the decision to sell goods relates to the quality of goods produced is not new. For example, Kim (1985) developed an adverse selection model in which car owners' maintenance and upkeep decisions affected the quality of used cars. Kim showed that allowing owners to affect the quality of goods could, under certain conditions, lead to an equilibrium in which the expected quality of used cars sold exceeds the expected quality of cars not sold. Similarly, we develop a theoretical model that extends a standard adverse selection specification by allowing owners (potential sellers) to improve a good's quality by expending unobserved effort. We show that owner effort only affects the adverse selection equilibrium when owners choose effort before they make the sell-retain decision.Owners decide whether to sell or retain a good once they observe their good's innate quality. Because buyers do not observe owner effort, the owner's dominant strategy is to expend zero effort on goods they will surely sell. Essentially, the model collapses to a standard moral hazard model, such as a fixed wage contract, in which employers cannot observe employee effort, and employees exert the necessary minimum effort to avoid dismissal. Because equilibrium effort equals zero, quality effects do not alter seller selection decisions and, therefore, the adverse selection equilibrium.Owners who must exert effort before they observe innate quality know only the probability that they will sell their goods and that the expected return to effort increases in the probability of retaining those goods. Because the probability of retention increases in seller incentives to select goods adversely, sellers who more likely select goods adversely also exert more effort. In this version of the model, no clear relationship exists between the expected quality of goods sold and the seller characteristics that Genesove (1993), and Chezum and Wimmer (1997) use to measure adverse selection. The model shows that uncertainty about whether a good will be sold partially solves the hidden action problem, in which owners underprovide effort and lessen the effect of adverse selection on markets.The notion that both adverse selection and moral hazard are important in markets affected by asymmetric information is well understood. …