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Dynamic Quality Signaling with Moral Hazard

  • Francesc Dilmé


    (Department of Economics, University of Pennsylvania)

Asymmetric information is an important source of inefficiency when assets (like firms) are transacted. The two main sources of this asymmetry are unobserved idiosyncratic characteristics of the asset (for example, quality) and unobserved idiosyncratic choices (actions done by the current owners). We introduce moral hazard in a dynamic signaling model where heterogeneous sellers exert effort to affect the distribution of a stochastic signal (for example sales or profits) of their firms. Buyers observe the signal history and make price offers to the sellers. High-quality sellers try to separate themselves from the less quality ones in order to receive high price offers, while the latter try to pool with the first group to avoid receiving a low price. We characterize the competitive equilibria of the model, and we propose an adaptation of existing refinements to the incorporation of moral hazard in dynamic signaling that implies uniqueness of equilibria. We find that similar individual characteristics across types of sellers make everyone worse off, since competition increases signaling waste. Also, due to the new intensive margin (effort), non-trivial signaling will take place even when the cost of signaling is large. In particular cases, we find analytical solutions, that allow transparent comparative statics analysis. The model can be applied to education where grades depend not only on the students’ skills, but also on their effort.

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Paper provided by Penn Institute for Economic Research, Department of Economics, University of Pennsylvania in its series PIER Working Paper Archive with number 12-012.

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Length: 42 pages
Date of creation: 19 Mar 2012
Date of revision:
Handle: RePEc:pen:papers:12-012
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  1. van Damme, E.E.C. & Nöldeke, G., 1990. "Signaling in a dynamic labor market," Other publications TiSEM b71cd444-f4c7-4282-bcc8-a, Tilburg University, School of Economics and Management.
  2. Kremer, Ilan & Skrzypacz, Andrzej, 2007. "Dynamic signaling and market breakdown," Journal of Economic Theory, Elsevier, vol. 133(1), pages 58-82, March.
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