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Lecture 2

Asymmetric Information: Adverse Selection


Alexander K. Koch
Department of Economics, Royal Holloway, University of London

January 23, 2006

In addition to learning the material covered in the reading and the lecture, students should
know the meaning of the terms private and hidden information, symmetric and asymmetric information, as well as adverse selection;
understand the intuition underlying problems of adverse selection;
be able to derive market equilibria under complete information;
be able to derive market equilibria under imperfect but symmetric information;
be able to derive market equilibria under asymmetric information;
understand the efficiency consequences of adverse selection;
be able to identify real-world situations in which adverse selection occurs.
Required reading:
Akerlof, George A., 1970, The market for lemons: Quality uncertainty and the market
mechanism, Quarterly Journal of Economics 84, 488500.
http://links.jstor.org/sici?sici=0033-5533\%28197008\%2984\%3A3\%3C488\
%3ATMF\%22QU\%3E2.0.CO\%3B2-6
Supplementary reading:
Chapter 13: Mas-Colell, Andreu, Michael D. Whinston, and Jerry R. Green, 1995, Microeconomic Theory (Oxford University Press: Oxford).

E-mail: Alexander.Koch@rhul.ac.uk.

Introduction

In many economic situations there is uncertainty about the quality of products or other important characteristics. Often such a situation is characterized by hidden information: one
individual or a group of individuals has private information, i.e., is better informed about
economically relevant aspects than others. Examples are:
In a market it is often the case that the selling party has better information about the
product than the buying party.
A bank deciding on whether to grant a commercial loan to a customer typically knows
less than the customer about the customers business. In particular, this means that the
customer has a better idea than the bank about the riskiness of the loan, having more
precise information about the probability of the business becoming bankrupt and loan
not being (fully) recoverable.
An insurance company offering automobile liability policies typically knows less about
the driving skills and habits of its potential customers than they do.
Workers applying for a job typically have a clearer idea of their skills and work habits
than potential employers do.
Such information asymmetries can lead to a problem called adverse selection which may cause
markets to shut down partially or even fully, despite potential gains from trade. We will use
Akerlofs (1970)1 famous example of the used car market to illustrate the problem of adverse
selection. Suppose that there are only two types of cars, good cars and bad cars (lemons),
where the fraction of all cars that are lemons is = 1/2. Assume that buyers and sellers in
this market are risk-neutral and that there are more potential buyers than used cars. A buyer
would be willing to buy a good car for 10, 000 but only pay 5, 000 for a lemon. Suppose
that a seller would part with a good car for 9, 000 and with a lemon for 3, 000.
Consider first the situation where nobody knows whether a car is a lemon or not. Then, a
buyers willingness to pay for a car of average quality is
value to buyer of car = (value to buyer of a lemon) + (1 ) (value to buyer of a good car)
= 7, 500.
1

George Akerlof was awarded the 2001 Nobel Prize for this path-breaking paper together with Michael

Spence (Lecture 3) and Joseph Stiglitz (Lectures 4, 5, 6 & 9).

A sellers reservation price is the value he or she attaches to a car of average quality,
E[value to seller of car] = (value to seller of a lemon) + (1 ) (value to seller of a good car)
= 6, 000.
Since there is Bertrand competition among buyers for used cars, the market price is 7, 500
and all sellers trade their cars.
Now consider the situation where the seller knows the quality of his or her car while buyers
cannot distinguish quality when they purchase a used car. Thus, the buyer must ask him or
herself Why is this person willing to sell the car to me? Suppose a car was offered at price
the buyer is willing to pay for a car of average quality, , 7, 500. Clearly all sellers with a
lemon would sell at that price. however, no seller with a good car would be willing to sell
since they would want to charge at least 9, 000. Thus, trade of used cars can only occur at a
price of 5, 000 and only lemons are traded. This leads to a loss of welfare since the potential
gain from trade of 1, 000 per good used car are not realized. Akerlof argues that adverse
selection might explain why there is a bigger difference in prices between new and used cars
than could plausibly be justified by the decline in usage value due to age.
With these ideas in mind, we will now turn to a model that puts a little more structure on
the problem of adverse selection. As we will see, with more quality levels adverse selection
can lead to a partial breakdown of markets despite potential gains from trade because of the
possibility of the bad [goods] driving out the not-so-bad driving out the medium driving out
the not-so-good Akerlof (1970, p. 490).

Model

Consider a market with m sellers (mathematically speaking, a mass of m) and (a mass of)
n > m buyers. Suppose that each seller owns one unit of a good. The quality of the sellers
goods is distributed according to distribution F on the interval [q, q], 0 < q < q. We will
assume that F is a uniform distribution2 , that is

0 f or
q<q

qq
F (q) =

qq f or q q q

1 f or
q > q
2

Appendix A reviews the uniform distribution.

(1)

and the density is


f (q) =

f or

q<q

f or q q q

qq

f or

(2)

q > q

Sellers maximize expected utility with Bernoulli utility function3


v(q, t) = q x + t

(0 < < 1),

(3)

where x {0, 1} is the amount of the good owned, q is the quality of the good, and t is the
amount of money the seller has. That is, a seller who owns a good of quality q has a reservation
price of q.
Each buyer is interested in buying at most one unit of the good. Buyers maximize expected
utility with Bernoulli utility function
u(q, t) = q x + t.

(4)

That is, each buyer is willing to pay up to q for a good of quality q.4

2.1

Complete information

We start off analyzing the benchmark case where both buyers and sellers can observe the
quality of goods (complete information). Each quality level q is visible to buyers and thus can
be viewed as a separate market. Consider a seller who owns a good of quality q. She values
the good less than the buyers since q < q. Thus, there is a potential gain from trade of
(1 ) q.

Recall that an expected utility maximizer faced with a lottery described by the random variable

x
= (x1 , x2 , . . . , xn ; p1 , p2 , . . . , pn ) has a von Neumann-Morgenstern utility function
n
X

U (
x) =

pi u(xi ),

i=1

where pi is the probability of outcome xi and u() is the agents Bernoulli utility function. If the lottery involves
a continuous random variable x
with outcome x [x, x
], distributed according to a distribution F with density
f , the expected utility is

U (
x) =

u(x) f (x) dx.


x

In this lecture we assume for simplicity that individuals are risk-neutral, i.e. u00 () = 0 and the von NeumannMorgenstern utility only depends on the expected value of the random variable describing possible outcomes.
4
We assume that buyers are not credit constrained so that they can pay any price p to acquire the good,
thus lowering their utility by p.

Let us first clarify what we mean, when we speak of an equilibrium in this context.
Definition 1 (Market equilibrium under complete information)
In a market equilibrium the following conditions must be satisfied:
1. All market participants maximize their utility, taking prices as given.
2. All markets q [q.
q ] clear:
X(p , q) = X s (p , q) = X d (p , q).

(MC)

The first condition states that all market participants are rational as well as self-interested and
operate under the assumption that their behavior does not affect prices. The second condition
is a standard market-clearing assumption: the number of goods traded in the market for
quality level q at the equilibrium price p , X(p , q), must equate the demand for goods at this
price, X d (p , q), with the supply of goods at this price, X s (p , q).
Since there are more potential buyers than there are goods (n > m), each seller can extract
the full surplus by charging a price of q for the good.5 Thus, in equilibrium the market will
clear at each quality level q at a price of p (q) = q and all goods change hands:
Z q
X(p (q), q) f (q) d q = m.
q

Note that the resulting allocation is Pareto-optimal since all gains from trade are realized,
and sellers are strictly better off than before while buyers are no worse off than if no trade
had occurred.6 The surplus created by trade under complete information (CI) is (see (6) for
derivation of E[q])
S CI =

m (1 ) q f (q) d q = m (1 ) E[q] = m (1 )
q

q + q
.
2

(5)

Proposition 1
Under complete information, in a market equilibrium
all goods are traded,
p (q) = q;
S CI = m (1 )

q+q
2 .

The market equilibrium leads to a Pareto-optimal allocation.


5

Buyers are in Bertrand competition with each other for the good since not all buyers demands can be

satisfied by other sellers.


6
This also follows from the First Fundamental Welfare Theorem, which states that a competitive equilibrium
is necessarily Pareto optimal if markets are perfectly competitive and there is complete information (i.e., markets
are complete).

2.2

Incomplete but symmetric information

Now consider the situation where both buyers and sellers (symmetric information) do not know
the quality of a particular good (incomplete information) to be traded. Since the quality of
goods is not distinguishable by any market participant at the time of trade, they are perfect
substitutes and there will only be one price for all goods traded in the market (i.e., there
is only one market instead of markets q [q, q] under complete information). The expected
quality of a good owned by a seller is
Z
E[q] =

q f (q) d q =
q


q
q2 q 2
q2
q
dq =
=
q q
2 (
q q) q
2 (
q q)

(
q q) (
q + q)
q + q
.
=
2
2 (
q q)

(6)

Assume that a sellers reservation price is simply E[q] = (


q + q)/2.
Supply of goods
As long as the market price falls short of the sellers reservation price, E[q], no one will be
willing to sell. In contrast, all sellers will be happy to sell if the price exceeds their reservation
price, leading to supply m. If the market price equals the sellers reservation price, they are
indifferent between selling and not selling so that supply will be any amount between [0, m].
Thus, the supply of goods is

X (p)

=0

f or p < E[q]

[0, m] f or p = E[q]
=m

(7)

f or p > E[q]

What is the expected quality of goods supplied? Since information is symmetric, the expected
quality of goods that are supplied at price p, denoted by Q(p), is equal to the expected quality
of all goods owned by sellers, E[q] for any price p at which sellers are willing to sell. If no
goods are sold, the quality is not defined: it is not possible to compute the expected value of
nothing. Hence,

not defined f or p < E[q]


Q(p)
= E[q]
f or p E[q]

(8)

Demand for goods


Buyers are not able to discriminate among the goods offered by sellers. However, they know
that sellers also cannot distinguish the quality of goods (symmetric information). Moreover,

buyers know the distribution of qualities across sellers, F , and are aware of the sellers preferences. Based on this information, buyers form beliefs about the expected quality of goods
sold in the market at the going price p, which we denote by Qe (p). If Qe (p) > p all n buyers
will want to buy a unit of the good since each would be willing to pay up to Qe (p) for it.
Thus, the amount demanded at these prices is X d (p) = n. In contrast, if Qe (p) < p no buyer
wants to purchase a good, leading to X d (p) = 0. Finally, if Qe (p) = p buyers are indifferent
between purchasing the good or not so that any level of demand X d (p) [0, n] is consistent
with maximizing behavior by buyers. To summarize,

=n
f or Qe (p) > p

X d (p)
[0, n] f or Qe (p) = p

=0
f or Qe (p) < p

(9)

Market equilibrium
We need to enrich our equilibrium concept to accommodate the incompleteness of information:7
Definition 2 (Market equilibrium under incomplete information)
In a market equilibrium the following conditions must be satisfied:
1. All market participants maximize their expected utility, taking prices as given.
2. Markets clear:
X(p ) = X s (p ) = X d (p ).
3. Market participants have rational expectations:

Q(p) f or p where X s (p) > 0


Qe (p) =
q
otherwise

(MC)

(RE)

The last condition states that buyers correctly anticipate seller behavior and can therefore
compute the expected quality of goods offered in the market at any given price. This means
7

This definition ignores some technicalities. For our purposes this loose definition will suffice. A rigorous

definition of equilibrium requires a game-theoretic foundation. The model that we analyze belongs to the class
of games of incomplete information to which one usually applies the concept of Bayesian Equilibrium. Roughly,
it states that in equilibrium the actions of each individual are best responses to the equilibrium actions of the
other players (i.e., the equilibrium is a Nash equilibrium). Because information is incomplete the concept also
demands that players beliefs about those aspects of the game for which information is incomplete are logically
consistent (which means that players are good statisticians who can apply Bayes rule). See, for example,
Mas-Colell, Whinston, and Green (1995), Chapter 9 (Chapters 7-8 introduce the fundamental concepts of game
theory).

that Qe (p) = Q(p) for any price for which sellers are offering a positive amount of the goods.
For prices p for which no goods are offered Q(p) is not defined: it is not possible to compute
the expected value of nothing. Thus, rational expectations do not pin down values for
Q(p) in this case and we have a degree of freedom.
Our model allows for any price p 0. As we saw, seller behavior can be perfectly characterized
for any such price by (7). However, to characterize buyer behavior using (9) we need to assign
a value to Qe (p) for prices where X s (p) = 0. Since we want a complete model that gives
predictions on the behavior of buyers and sellers for all possible price levels, we resolve this
technical issue by adding an assumption. For prices at which no goods are offered beliefs are
simply set to the lowest possible quality level:
Assumption:

Qe (p) = q

for all p for which

X s (p) = 0.

There are expected gains from trade for all units of the good since the sellers reservation
prices are lower than the expected utility of buyers from owning the good: E[q] < E[q].
As under complete information, since n > m, each seller can extract the full expected surplus
by charging a price of p = Qe (p ) = Q(p ) = E[q] for the good. This satisfies condition (RE).
All sellers will sell their good at the equilibrium price so that X s (p ) = m. Because n > m > 0,
the only way to equalize supply and demand is at quantity X(p ) = X s (p ) = X d (p ) = m.
This satisfies condition (MC): any demand between 0 and n i.e., also demand equal to m < n
is consistent with maximizing behavior because buyers are indifferent between buying and
selling at p = E[q]. The surplus created by trade under incomplete but symmetric information
(IS) is equal to the one under complete information: S IS = S CI . In our model we are taking
an ex ante viewpoint, where utilities are evaluated before quality becomes known. Thus, we
have an ex ante Pareto-optimal allocation.8
Proposition 2
Under incomplete but symmetric information, a market equilibrium exists in which
all goods are traded,
p = E[q] = (
q + q)/2;
S IS = S CI = m (1 )

q+q
2 .

This market equilibrium leads to an ex ante Pareto-optimal allocation.


8

Clearly, ex post a buyer who acquired a good that turns out to have quality q < p will be worse off than

if no trade had occurred (while the seller is better off) so that the equilibrium allocation will not be ex post
Pareto optimal as well.

share of all sellers in population of sellers: F(1)=1


share of all sellers for which q p/: F(p/)

F
F (1) = 1
p
F

p q

Q ( p ) = E [q q p / ]

Figure 1: Fraction of sellers supplying goods at price p

Taking stock of our results so far, we see that introducing imperfect information per se does
not lead to inefficient outcomes. All gains from trade are realized despite uncertain quality.
What matters is whether information is symmetric or not. In the next section we will see that
inefficiencies may arise once information is asymmetric.

2.3

Asymmetric information

Under this scenario the seller knows the quality of the good she owns, q, while potential buyers
do not (asymmetric information). Since the quality of goods is not distinguishable by buyers,
all sellers goods are perfect substitutes to buyers. Thus, as in the last section there will be a
single market price for all goods traded in the market.
Supply of goods
Recall that the reservation price of a seller who owns a good of known quality q is q, 0 <
< 1. At a given market price p only sellers with a good for which p q are willing to
sell. This is equivalent to q p/. Thus, at price p all sellers who own a good of quality no
bigger than p/ sell, while all other sellers hold on to their good. Figure 1 illustrates how to
obtain the share of sellers who are willing to sell at price p in the population of sellers. The
9

left panel plots the density function f . All sellers who own a good with quality not exceeding
p/ make up a fraction of the total population m equal to the ratio of the small hatched
box to the larger one that contains it. The surface of each of these boxes can be read off the
distribution function F . For example, the large box has a total surface equal to one, F (
q ) = 1,
since all sellers (mass m) own a good of quality that does not exceed the maximum possible
quality q. Thus, the distribution function F allows us to directly measure the proportion of
the population of sellers (total mass m) for whom q p/ as
p/

Z
F (p/) =

f (q) dq.
q

F for the uniform distribution is given in (1) and allows us to compute the quantity of goods
supplied at price p:

X s (p) = m F (p/) =

f or

m (p q)
(
q q)

p < q

f or q p q

f or

(10)

p > q

To compute the expected quality of goods that are supplied at a price p, we need to compute
the expected quality of the good, given that q p/: Q(p) = E(q|q p/). As a first step,
we write down the conditional density (see Appendix B):

f (q) =
p q f or q p/
F (p/)
g(q|q p/) =

0
f or q > p/

(11)

Since at prices p > q all goods are offered, a traded good then has expected quality equal
to the unconditional expectation Q(p) = E[q] =

q+
q
2 .

No goods are offered for p < q. The

expected quality of goods that are offered at price p [ q, q] is


p/

Z
Q(p) = E(q|q p/) =

p/

q g(q|q p/) d q =
q

p2
2

q2

q
dq
p q

2 (p q)

p + q
,
2

p [ q, q].

(12)

Thus, the supply schedule is

Q(p)

not defined
f or p < q
n p+ q q+q o
= min
f or p q
2 , 2

(13)

(Check that Q(p) given by equation (13) indeed is equal to the unconditional expectation at
q = q.) We see that under asymmetric information not only the quantity supplied in the
market, X s (p), but also the average quality of goods offered, Q(p), depend on the market
10

price. At a price p the marginal seller is offering quality level p/. If the price increases,
both quantity and average quality rise because sellers with higher quality goods now find it
worthwhile to also sell their good, pushing up the quality of the marginal seller and adding
to the quantity on the market. Moreover, the lower the taste of the sellers for their good, ,
the higher the average quality offered on the market for any given price (and the higher the
potential gains from trade). The average quality offered in the market reaches its maximum
level the average quality of all goods in the economy only if the market price exceeds the
reservation price of the owner of the highest quality item, q.
Demand for goods
Buyers are not able to discriminate among the goods offered by sellers but know that sellers
are aware of the quality of their own good. Unfortunately, there is no way to verify the claim
that sellers makes about the quality of her good, and buyers need to rely on the distribution
of qualities across sellers, F , and their knowledge of sellers preferences. Based on this information, buyers form beliefs, Qe (p), about the expected quality of goods sold in the market at
the going price p. As in the previous section, demand is given by

=n
f or Qe (p) > p

X d (p)
[0, n] f or Qe (p) = p

=0
f or Qe (p) < p

(14)

Market equilibrium
The definition of a market equilibrium is as in the case of incomplete but symmetric information, given by Definition 2. That is, in a market equilibrium the following conditions must be
satisfied:
1. All market participants maximize their expected utility, taking prices as given.
2. Markets clear:
X(p ) = X s (p ) = X d (p ).
3. Market participants have rational expectations:

Q(p) f or p where X s (p) > 0


Qe (p) =
q
otherwise

11

(MC)

(RE)

Does there exist an equilibrium with trade (X(p ) > 0)?


To see whether a market equilibrium exists in which a positive amount of the good is to
be traded, we examine whether X(p ) > 0 can be made compatible with the equilibrium
conditions.
Condition (MC) tells us that in equilibrium X(p ) = X s (p ) = X d (p ).
From the supply schedule in (10) we know that X s (p) > 0 if and only if p > q since
otherwise no seller is willing to offer the good. Hence, in equilibrium
p > q.

(15)

From the demand schedule in (14) we see that the market can clear at a positive quantity
if and only if Qe (p ) = p :
if Qe (p ) > p we have excess demand, X d (p ) = n > m X s (p );
if Qe (p ) < p we have zero demand, X d (p ) = 0;
if Qe (p ) = p condition (MC) can be satisfied since then for any value of p we
have X d (p ) [0, n], n < m, while X s (p ) (0, m], depending on p .
Hence, in equilibrium
Qe (p ) = p .

(16)

Condition (RE) together with (16) implies that in equilibrium


Q(p ) = Qe (p ) = p .

(17)

Thus, using (17) and (15) in conjunction with the supply schedule (10),


p + q q + q
,
= p .
min
2
2
n p + q q+q o
q
q+
Case 1: p = 2 = min
2 , 2
Case 1 arises if and only if p q. Together with p =
parameter must take on a value

q+
q
2 q .

q+
q
2

(18)

this implies that the

A final condition we have to check is (15)

since in equilibrium we must have p > q for there to be positive supply:


p =

q + q q + q
>
> q,
2
2

12

since

0 < < 1.

Case 2: If >
p

q
2 1 .

q
q+
2 q

we have that p =

p + q
2

= min

n p + q
2

q
q+
2

o
. This implies that

Again, we have to check condition (15):


p =
since

p > 0

2 1

q > q,

and thus

2 1

q>

1 > .

To sum up,

p =

q+
q
2
q
2 1

f or
f or >

q+
q
2 q
q+
q
2 q

(19)

Plugging p into equation (10), case 1 leads to trading of all goods since p q > q:
X(p ) = X s (p ) = X d (p ) = m,

for

q + q
.
2 q

Then, the surplus created is S AI = S IS . In other words, if sellers have a sufficiently low taste
for their own good, i.e. a low , asymmetric information does not lead to a problem of adverse
selection. All goods are traded and all potential gains from trade realized as in the case of
symmetric information.
In case 2 not all sellers trade in equilibrium,
X(p ) = X s (p ) = X d (p ) = m

2 (1 ) q
< m,
(2 1) (
q q)

for

>

q + q
.
2 q

The surplus created is lower than under symmetric information:


Z p /
p + q
q + q
AI
S =
(1 ) q f (q)d q =
< S IS = m (1 )
.
2
2
q
In case 2 sellers value their own goods sufficiently much (high ) so that owners of high quality
goods are not willing to trade at the prices for which lower quality goods trade. Since sellers
have private information about the quality of their goods a problem of adverse selection arises,
where goods of higher quality are not traded.
Proposition 3
Under asymmetric information, a market equilibrium exists in which all goods are traded if
and only if

q+
q
2 q .

Then
p q > q,

If >

and

S AI = S IS .

q+
q
2 q ,

X(p ) = m

2 (1 ) q
< m,
(2 1) (
q q)

p =

q
,
2 1
13

and

S AI =

p + q
< S IS .
2

45

E[q ]

E[q ]
Q( p)

q
p*

45

Q( p)

(a) Equilibrium: partial trade

q p *

(b) Equilibrium: trade of all goods

Figure 2: Market equilibria under asymmetric information

Thus, in contrast to the settings of complete information and incomplete but symmetric information, a market equilibrium in which all goods are traded only exists if

q+
q
2 q

(panel (b)

of Figure 2). Whenever the taste for quality of buyers and sellers does not diverge this much,
adverse selection drives out higher quality goods (panel (a) of Figure 2). This prevents the
full potential gains from trade to be realized, lowering the realized surplus from S IS to S AI .
Adverse selection becomes more severe, the more aligned the tastes of buyers and sellers are,
i.e., the closer is to unity (moving the point where the supply quality schedule Q(p) reaches
its maximum to the right).
From our results so far, we can see that adverse selection tends to drive out higher quality
goods. For all prices p < q the average quality offered in the market, q(p) is lower than the
average quality of all goods potentially available for sale, E[q]. Due to the quality uncertainty
for the buyers one price has to fit all goods. However, at prices lower than q owners of
higher quality goods prefer not to sell their goods, lowering the average quality of those goods
which are available for sale. This nicely confirms the intuition described by Akerlof of the
bad [goods] driving out the not-so-bad driving out the medium driving out the not-so-good.
A potential remedy to situations where adverse selection would arise is that sellers offer buyers
warranties. This allows buyers to inspect the good and return it if the quality does not match
14

x ~ U [x, x ]
f

F
1

1
xx

(a) Probability density function

(b) Cumulative distribution function

Figure 3: Uniform Distribution

that claimed by the seller. In the next lecture we will study another mechanism for reducing
uncertainty about quality: signaling.

Appendix
A

The uniform distribution

The uniform (or rectangular) distribution has constant probability over its support. A random
variable x follows a uniform (or rectangular) distribution, x U [x, x
], if it has constant
probability over its support [x, x
]. Its probability density function or just density (see
panel (a) in Figure 3) is given by

f (
x) =

0
1
x
x

f or

x<x

f or x x x

f or

15

x>x

(20)

f ( x)

f ( x x T ) = F (T )

F (T )

x T
x >T

f (x )

Figure 4: Conditional Distribution

Thus, the cumulative distribution function (see panel (b) in figure 3) is9

0
f or
x<x

xx
F (x) =

x
x f or x x x

1
f or
x>x

(21)

Conditional distributions and conditional expectations

The conditional density of x given that it takes on realizations lower than T is just the value
of the unconditional density normalized by F (T ) (see Figure 4):

f (x) f or x T
F (T )
g(x|x T ) =
0
f or x > T

(22)

The normalization is necessary since by definition the probabilities under a probability distribution sum up to one. With a continuous random variable this simply means that the area
R
under the density is equal to one: f (x) d x. Indeed, for the conditional distribution above
9

Rt

Recall that F (t) measures the area under the density function up to point t, i.e., F (t) = P rob(x t) =

f (x) d x.

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g(x|x T ) d x =

f (x)
dx =
F (T )

RT

f (x) d x

F (T )

RT
= R
T

f (x) d x

= 1.

(23)

f (x) d x

Recall that the expected value of a continuous random variable x with probability density
function f is computed as
Z

E[x] =

x f (x) d x.

(24)

Analogously, the conditional expectation is given by


Z

x g(x|x T ) d x.

x g(x|x T ) d x =

E[x|x T ] =

(25)

References
Akerlof, George A., 1970, The market for lemons: Quality uncertainty and the market
mechanism, Quarterly Journal of Economics 84, 488500.
Mas-Colell, Andreu, Michael D. Whinston, and Jerry R. Green, 1995, Microeconomic Theory
(Oxford University Press: Oxford).

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