Adverse selection in experience goods

History

The notion of adverse selection was first discussed in 1970 by George Akerlof in his paper The Market For "Lemons". Akerlof's primary example of averse selection was used automobile markets, which is an example of adverse selection in experience goods. However, Akerlof did not explicitly define either "adverse selection" or "experience good".

At around the same time, Phillip Nelson introduced the notion of experience good (contrasting it with the opposite notion of search good) in the paper Information and Consumer Behavior.

Definition

An experience good is a good for which it is hard for a potential buyer to ascertain the quality of the good before buying (and using) it. The problem of adverse selection for experience goods occurs when the buyer is uncertain about quality but the seller has better knowledge about the quality of the good. The problem is as follows:

• Factoring in the uncertainty in quality, the reservation price of the buyer (i.e., the maximum price the buyer is willing to pay) is less than the reservation price of the seller (i.e., the minimum price the seller is willing to accept).
• If the buyer were able to determine the quality of the good, the reservation price of the buyer would be higher than that of the seller, and the trade would have occurred.

References

Journal references

• The market for "lemons": quality uncertainty and the market mechanism by George Akerlof, Quarterly Journal of Economics, Volume 84,Number 3, Page 488 - 500(Year 1970): This paper discusses the problem of adverse selection, with used-car markets as the primary working example. It discusses adverse selection in experience goods as well as adverse selection in wages. The article does not explicitly use the term "adverse selection" more than once.^{JSTOR linkMore info}
• Information and consumer behavior by Phillip Nelson, The Journal of Political Economy, Volume 78,Number 2, Page 311 - 329(Year 1970): ^{JSTOR linkMore info}