Finance and Economics Discussion Series (FEDS)
Moldy Lemons and Market Shutdowns
This paper studies competitive market shutdowns due to adverse selection, where sellers post nonexclusive menus of contracts. We first show that the presence of the worst type of agents (moldy lemons) causes markets to fail only if their mass is sufficiently large. We then show that a small mass of moldy lemons can lead to a large cascade of exits when buyers possess outside options. Finally, we show that more precise information about agents' types makes markets more prone to exit cascades. The model is general and does not rely on institution details or structure, and thus can be applied to many different markets and context.
Note: The title of this paper was updated after initial publication.
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