Prices and Quality Signals

We consider a market-for-lemons model where the seller is a price setter, and, in addition to observing the price, the buyer receives a private noisy signal of the product’s quality, such as when a prospective buyer looks at a car or house for sale, or when an employer interviews a job candidate. Su¢ cient conditions are given for the existence of perfect Bayesian equilibria, and we analyze equilibrium prices, trading probabilities and gains of trade. In particular, we identify separating equilibria with partial and full adverse selection as well as pooling equilibria. We also study the role of the buyer’s signal precision, from being completely uninformative (as in standard adverse-selection models) to being completely informative (as under symmetric information). The robustness of results for these two boundary cases is analyzed, and comparisons are made with established models of monopoly and perfect competition. Keywords: lemons, adverse selection, noisy quality signals. JEL codes: C72, D82. SSE/EFI Working Paper Series in Economics and Finance, No. 551. We would like to thank Lars-Göran Mattsson for many inspiring discussions at the beginning of this research project, and Carlos Alos-Ferrer, Tore Ellingsen, Jianjun Miao and Zvika Neeman for comments to an earlier version. Voorneveld thanks the Jan Wallander and Tom Hedelius Foundation for …nancial support.