Asymmetric solutions to asymmetric information problems

Abstract

This paper studies markets plagued with asymmetric information on the quality of traded goods. In Akerlof's setting, sellers are better informed than buyers. In contrast, we examine cases where buyers are better informed than sellers. This creates an inverse adverse selection problem: the market tends to disappear from the bottom rather than from the top. In contrast to the traditional model, it is the high-value goods (gems) that are traded on the market, rather than the low-value goods (lemons). We refer to this asymmetric information scenario as the “market for gems.” We investigate the consequences of this undisclosed knowledge of hidden qualities — which we refer to as inverse adverse selection — and the reasons why legal theorists have given this form of asymmetric information substantially less consideration. Conventional legal and contractual solutions to the lemons problem are often ineffective in the gems case: the uninformed buyer in a traditional market for lemons experiences the quality of the good he purchased; in a market for gems, instead, the uninformed seller may never know the quality of the good that he sold. We study three alternative solutions to the gems problem — auctions, suppression of information, and inverse warranties — and identify the condition under which each of them is feasible. We then show how the theory sheds light on real-life gems problems arising in the multi-million dollar transactions involving soccer players, artworks, M&As, Hollywood movies, and diamonds.