Evidence of Adverse Selection from Thoroughbred Wagering.

• Author: Chezum, Brian

Brian Chezum [*]

Bradley S. Wimmer [+]

Previous research has shown the thoroughbred sales market to be affected by adverse selection. In the market, sellers who race as well as breed thoroughbreds will choose to keep thoroughbreds when their estimated private values exceed expected sales prices. The presence of asymmetric information leads these sellers to sell their low-quality horses and keep their best for racing. We extend the analysis by examining how bettors use similar information when wagering on thoroughbred races. We show, using a sample of two-year-old maiden races, that homebreds (those horses kept by their breeders for racing) are favored over otherwise similar nonhomebreds.

1. Introduction

   In his Lemons Market example, Akerloff (1970) shows that some mutually beneficial trades will not occur when sellers have private information about the quality of goods. Essentially, a buyer's best estimate of the quality of any seller's good is the market average, and sellers of high-quality goods may not enter the market. Although there is little dispute over the theoretical underpinnings of Akerloff's Lemons Market, relatively few empirical studies present evidence illustrating this outcome. Some examples are Greenwald and Glasspiegel (1983), Gibbons and Katz (1991), Genesove (1993), and Chezum and Wimmer (1997).

   These papers relate data on prices with distinguishing characteristics of sellers to show that sellers with "adverse" characteristics receive lower prices. For example, Chezum and Wimmer, examining the thoroughbred yearling sales market, show that prices commanded by sellers who also race thoroughbreds are lower than prices commanded by sellers who sell all of their thoroughbreds. Intuitively, breeders will take a thoroughbred to market when the expected market price exceeds the value they would receive from retaining the animal. If private information is important and costly to transmit, prices for thoroughbreds sold by racing-intensive breeders will be lower than those received for similar thoroughbreds sold by breeders who do not race. [1]

   This paper extends this intuition by examining how bettors evaluate two-year-old thoroughbreds when they reach the track. If breeders adversely select the horses they sell, a horse retained by a breeder should be of a higher average quality. If betting markets are efficient, a finding that bettors expect homebreds (horses retained by their breeders) to outperform horses that were sold indicates that adverse selection is present in the market for thoroughbreds.

   Studies of betting markets have found that bettors predict the outcome of horse races (and other sporting events), relatively accurately. [2] These studies show that bettors are able to aggregate disparate pieces of information efficiently. Use of betting information therefore provides an opportunity to examine how markets incorporate information on breeders' decisions to keep or sell thoroughbreds in settings other than a sale. Such a test of adverse selection is relatively unique to the literature because it does not rely on sales data to determine whether adverse selection is present in a market. [3] The use of race data allows us to compare the quality of goods retained by their producers with that of those offered for sale.

   This prediction is clarified in section 2. Section 3 describes the data used to test our prediction and the empirical strategy. Using data from a set of races run by two-year-old Thoroughbreds conducted at the Keeneland and Saratoga racecourses in the summer and fall of 1995, we find that homebreds are favored over otherwise similar nonhomebreds as reflected by the post-time odds of a race.

2. Thoroughbred Sales Markets and Betting Behavior

   In the thoroughbred industry, owners obtain thoroughbreds for racing by purchasing them privately, at auction, or through their own breeding operations. [4] In turn, breeders may be classified as one of three types: those who sell all of their thoroughbreds, those who race all of their thoroughbreds, and those who both sell and race thoroughbreds. Breeders who keep a portion of their crop are expected to use private information to determine which thoroughbreds they keep to race.

   In the time before breeders take their thoroughbreds to market, they observe how their horses respond to other thoroughbreds, have access to their horses' complete medical histories, and are generally able to identify their thoroughbreds' temperaments. Although these factors do not predict future on-track success perfectly, they do give the seller an informational advantage over buyers. At thoroughbred auctions, information on a thoroughbred's breeding is available and buyers are allowed to inspect thoroughbreds prior to the sale. However, buyers do not have access to the information that the seller possesses. Because buyers do not have perfect information, sales prices reflect the average quality of thoroughbreds offered for sale with similar breeding and visual characteristics.

   Sellers who also race are expected to use private information to determine which thoroughbreds to take to market. As in the standard lemons model, the presence of bad thoroughbreds forces the average price down, and the highest quality yearlings are likely to exit the market. If buyers know this, they expect the average quality to decline and, as in Akerloff (1970), the market may collapse. Genesove (1993) examines a model in which buyers and sellers have identical tastes but sellers are capacity constrained so that some thoroughbreds are sold for reasons other than adverse selection. The presence of capacity constraints generates an equilibrium with positive prices because buyers do not know whether a seller is selling a thoroughbred because it is capacity constrained or because the horse is being adversely selected. In this model, price reflects the average quality traded, and sellers take their lowest quality horses to market to ease their capacity constraints. This may describe the thoroughbred industry because participants who race are limited in their capacity to maintain a large stable. [5]

   When horses reach the racetrack, they race for a portion of a purse that is typically funded through pari-mutuel wagering. [6] Consumers bet on the order of finish. Simple bets are those for win, place, and show (first, second, and third, respectively). A bettor receives a payoff when the horse on which he wagered finishes in the wagered position or better. For example, a show bet will pay if the horse finishes first, second, or third [7] Each wager type has its own pool, which is the sum of money bet on all horses for each type of wager. Payoffs are based on the relative proportion of money bet in the appropriate pool on each horse in the race. These payoffs are indicated by the odds. As the relative amount bet on a horse increases, the odds and subsequent payoffs fall.

   Bettors analyze available information to predict how the horses entered in a race will finish. This process is referred to as handicapping. The object of handicapping is to allocate available funds in a way that maximizes expected returns. [8] The question of interest is how bettors use information on whether a horse was sold before it reached the track when making their wagers. This information, as well as other relevant handicapping information, is published in The Daily Racing Form. [9]

   If bettors know that breeders may keep some of their yearlings, and that breeders are more likely to sell horses from the lower end of the distribution, they should expect thoroughbreds being raced by their breeder to be of higher average quality and a test for adverse selection arises. Specifically, bettors should favor thoroughbreds that are kept by their breeder over otherwise similar thoroughbreds.

   More formally, presume that horses in a race are drawn from a quality distribution F(q), on the interval ([q.sub.L],[q.sub.H]) here q indexes quality (L indicating low quality). Higher-quality horses are more likely to win races. With no other information, the best estimate of a horse's quality is the mean quality from the known distribution. If bettors know a horse is a homebred, they also know that the breeder has chosen to race, rather than sell, the horse. If thoroughbreds taken to auction are adversely selected, the signal that the horse is a homebred indicates that it is drawn from the top of the distribution. That is to say, homebreds are drawn from the interval ([q.sup.*],[q.sub.H]), where [q.sup.*] [greater than] [q.sub.L]. [10] Bettors should favor homebreds over otherwise similar nonhomebreds.

   It is worth noting that a breeder may race a particular horse for many reasons. Some breeders will keep a portion of their female horses because they are inputs in the future breeding process. Also, a breeder may be "stuck" with a horse because it was ill at the time of a sale. [11] The weight put on the homebred characteristic may be discounted if such information is available to bettors.

3. Data and Empirical Strategy

   We test our hypothesis by examining data on two-year-old maiden races conducted during the summer and fall of 1995 at the Saratoga and Keeneland racecourses. [12] We examine two-year-old maiden races to highlight the differences that might exist in bettors' perceptions based on the distinction that a horse is or is not a homebred. We define a homebred as a horse that has at least one entity listed as both its breeder...