Dynamic market for lemons with endogenous quality choice by the seller

We analyze a dynamic market for lemons in which the quality of the good is endogenously determined by the seller. Potential buyers sequentially submit offers to one seller. The seller can make an investment that determines the quality of the item at the beginning of the game, which is unobservable to buyers. At the interim stage of the game, the information and payoff structures are the same as in the market for lemons. Our main result is that the possibility of trade does not create any efficiency gain if (i) the common discounting is low, and (ii) the static incentive constraints preclude the mutually agreeable ex-ante contract under which the trade happens with probability one. Our result does not depend on whether the offers by buyers are private or public. ∗The author thanks Eddie Dekel, Jeffery Ely, Atsushi Kajii, Wojciech Olszewski, Alessandro Pavan, Asher Wolinsky, and seminar participants at Kyoto University for useful discussions and valuable comments. The author also acknowledges the financial support from the Center for Economic Theory of the Economics Department of Northwestern University. †Department of Economics, Northwestern University; [email protected].