Behavioral Equilibrium in Economies with Adverse Selection

I propose a new solution concept–behavioral equilibrium–to study environments with players who are naive, in the sense that they fail to account for the informational content of other players’actions. A behavioral equilibrium requires that: (i) players have no incentives to deviate given their beliefs about the consequences of deviating; (ii) these beliefs are consistent with the information obtained from the actual equilibrium play of all players; and (iii) when processing this information, naive players fail to account for the correlation between other players’actions and their own payo¤ uncertainty. I apply the framework to certain adverse selection settings and show that, contrary to the received literature, the adverse selection problem is exacerbated when naive players fail to account for selection. More generally, the main distinguishing feature of the framework is that, in equilibrium, beliefs about both fundamentals and strategies are jointly restricted. Consequently, whether a bias may arise or not is determined endogenously in equilibrium. Keywords: Behavioral game theory, adverse selection, winner’s curse, self-con…rming equilibrium