The market for lemons and information theory

Abstract

Spence’s theory of signaling shows that signals can resolve adverse selections in job markets. Instead of signals, I consider what Spence calls indices and show that if the costs of knowing the indices are not nil, they could play the role of resolving adverse selection in sequential Bayesian games. I also show that by incorporating costs that are measured by the mutual information of indices, adverse selection can be resolved if the costs fall within a certain range.