Competition and the Signaling Role of Prices

Abstract

In a market where sellers are endowed with heterogeneous qualities of the same good and are more informed than buyers, high quality sellers' chances to trade might depend on their ability to inform buyers about the quality of the goods they offer. We study under what conditions and to what extent sellers of high quality goods are able to overcome such a need for communication by means of pricing decisions in the context of a market populated by a large number of strategic price setting sellers and a large number of buyers. The unique robust equilibrium outcome - in terms of prices, quantities and qualities traded - depends upon market conditions. If demand is strong so that sellers face weak competitive pressure, sellers of high quality goods are able to use prices as a signaling device and this enables them to trade. However, not all sellers of high quality are ex-post able to sell. In particular, if demand is sufficiently strong, high quality sellers become rationed. If demand is weak, competition among sellers inhibits the role of prices as signals of high quality, and high quality sellers are driven out of the market.