Endogenous Market Thickness and Honesty: A Quality Trap Model

Many economies, particularly emerging or transition economies lack institutional arrangements (like ISO certification) to credibly signal product quality. The absence of such institutions leads to low levels of market activity with poor quality products on sale. In this paper, we use a dynamic framework with asymmetric information to model this phenomenon. Sellers choose the quality they produce and face a trade-off between producing a high quality product, which gives low one period returns but leads to higher future profits, and a low quality product, which gives higher one period returns but bars the seller from future market activity. Sellers' differ in how they discount the future and thus in how they evaluate this trade-off. Demand is endogenous and the number of buyers that enter the market depends on the quality of the products they expect to find. Market thickness (the buyer-seller ratio), product quality, prices and the distribution of seller types are all endogenously determined and multiple steady states may emerge. In general, a sufficient number of sellers need to be patient for multiple steady states to exist. Technology that involves 'learning by doing' may cause market segregation. Importantly, sellers’ expectations about market thickness matter in determining the quality only if sellers believe that market thickness will be less than one.