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Asymmetric Information and Overinvestment in Quality

  • Paul Belleflamme
  • Martin Peitz

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.

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Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 2619.

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Date of creation: 2009
Date of revision:
Handle: RePEc:ces:ceswps:_2619
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  18. repec:oup:qjecon:v:87:y:1973:i:3:p:355-74 is not listed on IDEAS
  19. Nelson, Philip, 1974. "Advertising as Information," Journal of Political Economy, University of Chicago Press, vol. 82(4), pages 729-54, July/Aug..
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