Adverse selection is an important source of market inefficiency and markets for durable goods are particularly likely to suffer from adverse selection. Indeed the used car market is the prototypical example of a market subject to adverse selection. In any of these markets adverse selection is a potential problem because first owners learn the quality of the good and then decide whether to trade them in the used market. This research will analyze a market where a flow of output of new units arrives every period, consumers self-select into buying new or used cars. Thus, in contrast to the previous literature on adverse selection, the ownership of cars is endogenous. Preliminary results indicate that incorporating in the analysis the market for new goods has important consequences. First, the volume of trade in the used market is always less than 100%, but the used market never closes. This is a consequence of the fact that, in contrast with the previous literature, in this model a seller of a used car gets to buy a new car instead of being left with nothing. Second, this research suggests that there are new dimensions in the analysis of social welfare that put in question some `common wisdom` concerning adverse selection. In particular, an example shows that welfare can be higher under adverse selection than when all consumers are required to trade or, alternatively, when there is no quality uncertainty. Third, this framework allows consideration of the effects of adverse selection on the market for new durable goods and, therefore, on manufacturer incentives to influence the behavior of consumers in the presence of adverse selection. It is possible that a worsening of adverse selection may benefit a monopolist, who may then produce unreliable cars. This research will then analyze contractual arrangements that the manufacturers can employ to affect the behavior of consumers: the transferability of warranty coverage between owners, manufacturers refurbishment and certification of the used, and the structure of leasing contracts.
