2.1 The Mechanism: The Adverse Selection Death Spiral

Use this recipe to describe why a market with hidden quality can unravel from a fully-trading equilibrium down to a lemons-only equilibrium (or to no trade at all). It is the qualitative mechanism behind Akerlof's lemons result and the insurance death-spiral.

1. Buyer cannot distinguish quality, so they offer an average-quality price.
2. High-quality sellers receive a price below their reservation value and exit the market.
3. Average quality in the remaining pool falls.
4. Price falls further in response — triggering more exits.
5. This continues until only the lowest quality remains (market collapse / lemons market).

type: lemons-threshold

The blue line is the buyer's expected value as the share of good cars $p$ rises; the red dashes are the good-car seller's reservation price. Below the threshold (red zone) only lemons trade; above it the good equilibrium can exist, but the lemons equilibrium still co-exists — beliefs are self-fulfilling.

Common pitfalls

• Pitfalls not covered in source — review and add.

Worked example

The lecture's used-car market: good cars (buyer value $3,000, seller value $2,800), bad cars (buyer value $2,000, seller value $1,800), share of good cars $p = 0.75$. Testing "both types trade" gives $E[\text{buyer value}] = 0.75 \times 3000 + 0.25 \times 2000 = \$2{,}750 < \$2{,}800$, so good sellers exit. Re-test with "only bad cars trade": buyer value = $2,000 ≥ seller value $1,800 → equilibrium. Only lemons sold, classic market failure.