The Informative Role of Prices in Markets with Endogenously Informed Buyers

Abstract

Sellers are typically better informed about product quality than their customers. Because sellers have an incentive to misrepresent quality, it may not be possible for market prices to effectively convey this information to rational consumers, as was first argued by Akerloff (1970). The purpose of this paper is to argue that even if sellers are initially better informed than buyers, prices may yet be informative if buyers can purchase additional information about quality from an external, reliable source. In this setting, the informative role of prices is shown to depend crucially on the cost of external information to consumers. In particular, there exists a critical value such that when the cost of information is below this value, the market equilibrium is characterized by two distinct prices and a different pricing strategy for each type of seller. High quality sellers deterministically charge the high price while low quality sellers randomize between the low price, which corresponds to the low quality price that obtains under conditions of complete information, and the high price. The equilibrium frequency with which the high price is mimiced by low quality sellers decreases as the cost of information grows smaller and goes to zero in the limit. Correspondingly, the level of the high price increases as the cost of information decreases and approaches the complete information high quality price in the limit. Thus the less costly it is for buyers to become independently informed, the less noise the low quality seller generates and the more informative about quality the high price is.