At a Great Bargain, Pause.

“At a Great Bargain, Pause.”^[3]

If a litigant offers to settle a case on overly favorable terms, you should question his kindness. Similarly, you should be wary of accepting any business offers that seem too generous. Imagine that an acquaintance starts a new business. You have studied the venture and estimate that it should be worth $10 million. Your acquaintance offers you 10 percent of the business for only $500,000. You had previously thought that 10 percent of the business was worth one million dollars, so should you accept? When you were offered 10 percent of the business for $500,000, you gained a valuable piece of information. A person who knows more about the business than you would be willing to trade 10 percent of it for $500,000. Perhaps this is because she needs the money, but it’s also possible that your acquaintance knows that 10 percent of the business is not worth what you had thought, so you should study the business further before investing in it.

Adverse selection comes into play when the seller knows more about the good than the buyer. The seller is always going to be more willing to sell an item the lower its quality. If the seller knows more about the quality of the good than you, you should assume that the seller’s willingness to part with the item signals that he might think the item is of poor quality. This doesn’t mean that you should never accept any offer. There are many instances where it’s possible for you to benefit from a deal that also would benefit your potential partner. It could be that your potential partner needs your financing or expertise so she is really willing to make an offer that would make you better off. When a prospective partner knows more about a deal then you do, however, you should always examine her incentives for interacting with you.

^[3]Browning (1989), 359.