Asymmetric Information and Overinvestment in Quality

Paul Belleflamme () and Martin Peitz

No CESifo Working Paper No. 2619, CESifo Working Paper Series from CESifo Group Munich

Abstract: In a standard adverse selection world, asymmetric information about product quality leads to quality deterioration in the market. Suppose that a higher investment level makes the realization of high quality more likely. Then, if consumers observe the investment (but not the realization of product quality) before purchase, they can infer the probability distribution of high and low quality that may be put on the market. We uncover two effects that may lead the firm to overinvest in quality compared to a market with full information: first, an adverse selection effect according to which a sufficiently large investment can avoid adverse selection and, second, an efficiency effect according to which a larger investment reduces the probability of socially inefficient, low quality products in the market.

Keywords: asymmetric information; product quality (search for similar items in EconPapers)
JEL-codes: D82 D92 L15 (search for similar items in EconPapers)
Date: 2009
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