Pre-Trade Private Investments

Abstract

This paper investigates the welfare effects of private investments prior to trade. A seller of a durable good can privately invest on changing its quality. After the investment, she receives a take-it-or-leave-it offer from a buyer. Both the seller and the buyer value more goods of higher quality. We obtain that, in equilibrium, the seller mixes the investment choice, adding adverse selection to the exchange. The non-observability of the investment lowers the buyer’s payoff without giving the seller additional rents. Adding buyer competition exacerbates the adverse selection and completely eliminates the trade surplus. Partial observability increases the equilibrium investment, makes the seller better off, and lowers the payoff of the buyer.