SFB 303 Discussion Paper No. A - 082

Author: Hellwig, Martin
Title: Some Recent Developments in the Theory of Competition in Markets with Adverse Selection
Abstract: Over the past twenty years, economists have become more and more interested in the functioning of markets with incomplete information. The simplest case is that of one-sided incomplete information, where one side of the market has private information about some relevant characteristic of the good that is being traded. Most of the literature dealing with markets which have sorting devices is not very explicit about what exactly is meant by "competition" in a market with adverse selection, i.e. what is the game-theoretic structure of the strategic interaction between informed and uninformed agents in the market. To some extent, this neglect is due to a reluctance to narrow the intuitive concept of "competition" down to one specific game-theoretic model. However, two new contributions by Cho and Kreps (1986) and by myself (forthcoming) suggest that the conclusions which have been reached are very sensitive to the details of the game-theoretic specification that one looks at. Seemingly minor modifications of the formal model have a major impact on the predicted outcome of "competition" in a market with adverse selection. In this paper, I shall compare the different specifications and try to give some insight into why the details of the game-theoretic modelling of competition matter as much as they do. Thus the informed party`s behaviour will depend on its information, and, e.g., in the insurance market, a consumer who believes that his accident probability is high will buy more insurance than a consumer who believes that his accident probability is low. If the other side of the market is aware of this "adverse selection" phenomenon, then it will try to infer the underlying private information from the observed behavior of the informed party. The question is how this inference process affects the functioning of the market.
Creation-Date: October 1986
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