Endogenous Entry in Markets with Adverse Selection∗

Since Akerlof’s (1970) seminal paper the existence of adverse selection due to asymmetric information about quality is well-understood. Given the negative implications for trading and welfare, the question arises of how such markets come into existence. We consider a market in which firms make observable investment/entry decisions that generate products of a quality that becomes known only to the firm. Entry has the tendency to lower prices, which may lead to adverse selection. The implied price collapse limits the amount of entry so that high prices are supported in the market equilibrium, which results in above normal profits. While contributing to our understanding of markets with asymmetric information and adverse selection, the model may also provide insight into the question of why markets with adverse selection are empirically hard to identify. The analysis suggests that rather than observing the canonical market collapse, such markets may instead be characterized by less entry than would be empirically predicted and above normal profits even in markets with low measures of concentration.