Signalling to Competing Retailers: Receiver Discretion and Adverse Selection

In many industries manufacturers are more well-informed than retailers about the strength of final demand. We analyse a signalling model in which a monopolist manufacturer signals final demand, which can either be high or low, through his choice of wholesale price. The retailers then engage in price competition in differentiated products. We show the existence of a unique, refined equilibrium outcome, at which the two types of the manufacturer choose different wholesale prices. If the number of retailers is sufficiently large, both wholesale prices will equal their full information value, whereas if the number of retailers is "insufficient", the manufacturer with information that demand is low will distort his wholesale price downward. The effect of increased retail competition is to thwart retailer market power and diminish the sensitivity of retailer behaviour to beliefs about final demand, and this alleviates the adverse selection problem embedded in the signalling game. Hence, at a more abstract level, the analysis contributes to our understanding of adverse selection in the face of varying receiver discretion.