Using a simple theoretical model, we document an important characteristic of adverse selection in secondhand markets: goods with higher observed quality may have more adverse selection. The intuition is as follows. If observed quality has deteriorated significantly since the good was originally purchased, there is a clear sorting motive for the car to trade from the higher-valuation current owners to lower-valuation buyers. However, if observed quality has not deteriorated, there must be some other, often less transparent, reason for the car to be on the secondhand market. An important reason may be hidden defects. Using data on used cars from the Consumer Expenditure Survey, we find empirical support for this result.
Jonathan R. Peterson and Henry S. Schneider. 2013. "Beautiful Lemons" The SelectedWorks of Henry S Schneider
Available at: http://works.bepress.com/henry_schneider/7