Adverse Selection, Seller Effort, and Selection Bias

Abstract

Several studies (Genesove 1993; Chezum and Wimmer 1997) use evidence of a correlation between seller characteristics and prices as evidence of adverse selection. This approach ignores the effect seller effort might have on the quality of goods sold. We develop a theoretical framework that accounts for both adverse selection and seller effort and provide a set of conditions under which sellers, who more likely adversely select the goods they sell, produce higher quality goods. Empirically, adverse selection emerges as a special case of selection bias. To disentangle the effects of adverse selection from seller effort, we employ a unique data set that allows us to model the selection decision explicitly. The evidence suggests that both adverse selection and hidden effort play important roles in the market for thoroughbred racehorse prospects.