ArticlePDF Available

Abstract

In a standard adverse selection world, asymmetric information about product quality leads to quality deterioration in the market. Suppose that a higher investment level makes the realization of high quality more likely. Then, if consumers observe the investment (but not the realization of product quality) before purchase, they can infer the probability distribution of high and low quality that may be put on the market. We uncover two effects that may lead the firm to overinvest in quality compared to a market with full information: first, an adverse selection effect according to which a sufficiently large investment can avoid adverse selection and, second, an efficiency effect according to which a larger investment reduces the probability of socially inefficient, low quality products in the market.
Electronic copy of this paper is available at: http://ssrn.com/abstract=963229
Asymmetric Information and
Overinvestment in Quality
Paul Belleflamme,
Martin Peitz
Working Paper 49/2007
Bruchsal, January 2007
ISSN 1613-6691 (print version)
ISSN 1613-6705 (online version)
Prof. Dr. Martin Peitz is Professor of Economics and Quantitative Methods at International
University in Germany, Bruchsal.
Prof. Paul Belleflamme, Ph.D. is Associate Professor at Université Catholique de Louvain.
Contact: martin.peitz@i-u.de, belleflamme@core.ucl.ac.be
School of Business Administration
Electronic copy of this paper is available at: http://ssrn.com/abstract=963229
Asymmetric Information and
Overinvestment in Quality
Paul Belleamme
Université Catholique de Louvain
Martin Peitz
International University in Germany and University of Mannheim
This version: January 2007
Abstract
According to standard economic wisdom, asymmetric information
about product quality leads to a quality deterioration in the market.
Suppose that a higher investment level makes the realization of high
quality more likely. Then, if consumers observe the investment (but
not the realization of product quality) before purchase, they can infer
the probability distribution of high and low quality that may be put on
themarket. This,asweshow,maymaketherm overinvest in quality
compared to a market with full information.
Keywords: asymmetric information, product quality
JEL-Classicati on : D82, D92, L15
CORE and IAG-Louvain School of Management, Université Catholique de Louvain,
34 Voie du Roman Pays, B-1348 Louvain la Neuve, Belgium, belleamme@core.ucl.ac.be.
Department of Economics, University of Mannheim, 68131 Mannheim, Germany,
Martin.Peitz@i-u.de; also aliatedwithCEPR,CESifoandENCORE.
1 Introduction
We exa m ine t he eects of asymmetric information on rms’ incentives to
invest in the quality of their product. Asymmetric information prevails be-
cause consumers cannot ascertain the quality of the product before they buy
it. However, through a risky investment, rms have the ability to increase
the average quality of their product. Consumers can observe the investment
level and thereby, obtain information about the expected quality in the mar-
ket. Using a simple model, we show that in such a situation, rms might
end up investing more in quality under asymmetric information than under
full information.
We provide two simple arguments that support the overinvestment re-
sult. First, under asymmetric information low quality is always put on the
market whereas it is not oered if the willingness-to-pay is below the cost
under full information. From an ex ante point of view, the rm can then
increase its prots by overinvesting compared to the full information case
because this reveals to consumers that the risk of obtaining low quality is
reduced, which is reected in the price. Second, we have to take the partic-
ipation constraint of the high-quality rm into account if it is more costly
to produce high quality than low quality. Under asymmetric information,
the price that can be charged increases in the probability that high quality
will result. To make sure that high quality stays in the market, this price
has to be above the cost of high quality because otherwise a lemons problem
arises. The existence of the lemons problem, in turn, may make it optimal
for the rm to distort the investment level upward.
Key requisite for our result is the consumers’ ability to draw inferences
from investment levels on expected product quality. For instance, pharma-
ceutical rms provide information about their input in research and devel-
opment for a particular prescription drug, apparently to make prescribing
doctors and hospital pharmacists think that their product is likely to be suc-
cessful. In the cosmetics industry, the leading company, L’Oréal, emphasizes
in its advertisement campaigns the large number of patents it les every year
(over 500 in 2005) and how much it invests in cosmetic and dermatological
research (3% of sales or $625 million in 2005), so as to convince consumers
1
of its commitment to market high-quality products. Hollywood studios hire
well-known actors with the idea that these actors lead to better movies on
average. Producers of wines, organic food and other food products invest in
production processes (and inform consumers about these investments) with
the idea that the adoption of such processes leads to better products on
average.
The type of investment we have in mind can also be exemplied by a
rm’s eort to meet standards for quality management systems, such as ISO
9000. The ISO 9000 certication does not guarantee the quality of end prod-
ucts and services; rather, it certies that consistent business processes are
being applied. That is, it proves that the rm (actually, any type of organi-
zation) has put in place the necessary processes (i.e., a quality management
system) “to full the customer’s quality requirements, and applicable reg-
ulatory requirements, while aiming to enhance customer satisfaction, and
achieve continual improvement of its performance in pursuit of these ob-
jectives.”1Cole (1998, p. 68) conrms our view by suggesting that rms
may make ISO 9000 “their primary instrument for signaling quality to their
customers.”2
While there is an abundant economic literature on quality in asymmet-
ric information situations, we are not aware of work that obtains a result
similar to ours.3Inspired by previous work that alludes to the adverse se-
1Taken from www.iso.org (ISO 9000. Understanding the basics).
2However, rms may also seek certication simply in compliance with requirements of
major customers or regulators. To disentangle the relative importance of these two moti-
vations, Anderson et al. (1999) estimate a probit model of ISO 9000 certication. They
show that the signaling motivation is indeed important: the desirability of communicating
quality outcomes to external parties provides incremental explanatory power for the cer-
tication decision (even after including compliance motivations for seeking certication).
Quality management systems seem thus to correspond to the type of investments we refer
to in our model.
3This literature starts with Akerlof’s (1970) “lemons’ principle”, according to which
adverse selection (resulting from asymmetric information) causes the bad quality to drive
the good quality out of the market. Various ways have then been explored to remedy, or at
least alleviate, the underprovision of quality that prevails under asymmetric information.
For instance, Leland (1979) has explored the role of minimum quality standards as a policy
to cope with the underprovision of quality. Price and advertising signals are other means
by which rms may reduce the asymmetric information and convince consumers of the
2
lection problem arising from an unmodeled investment in quality (see, e.g.,
Milgrom and Roberts, 1986), we explicitly model that the level of the in-
vestment aects the probability distribution over quality and show that due
to asymmetric information, the rm may overinvest in quality.
In an important paper, de Meza and Webb (1987) obtain an overinvest-
ment result of a dierent sort. They consider a competitive market in which
entrepreneurs face an asymmetric information problem when asking for out-
side nance. Entrepreneurs have to make the same level of investment to
enter the market but they dier in the probability to be successful. De
Meza and Webb show that too many entrepreneurs invest. In their model
the overinvestment result directly stems from the adverse selection frame-
work that makes high-quality projects draw in low-quality projects.4Hence,
in their model more aggregate investment lowers average quality. This is in
line with the general tenor in the literature that asymmetric information
problems tend to lead to a quality deterioration. By contrast, in our model,
in which a higher investment level increases the probability of high quality,
asymmetric information may lead to higher quality.
Creane (2006) considers a market in which an unlimited number of ho-
mogeneous rms decide whether to enter with uncertain quality. After entry,
rms observe the quality; high quality is more costly than low quality. The
number of rms, determined by the free entry condition according to which
high and low quality rms stay in the market, is not sustainable because
the participation constraint of high-quality rmsisviolated,andthuswould
lead to adverse selection. Therefore rmsenterinsmallernumberandob-
tain positive equilibrium prots under free entry. While Creane considers
entry for a given investment level we analyze the situation for a given rm
good quality of their product; see, e.g., the seminal contributions by Nelson (1974) and
Milgrom and Roberts (1986). In a price-signalling context, Shieh (1993) has analyzed the
investment incentives in cost-reducing innovations under asymmetric information, where
neither the investment nor product quality is observable to consumers. He shows that
asymmetric information about quality may strengthen the rm’s incentive to invest in
cost-reducing innovation.
4In a related model, Lensink and Sterken (2001) also obtain an overinvestment result,
which however stems from the possibility to delay the investment decision and not from
the heterogeneity of expected returns of projects.
3
in which the probability distribution over quality is continuously aected by
the investment level.
The paper is organized as follows: in Section 2, we lay out the model; in
Section 3, we analyse the benchmark of full information; in Section 4, we de-
velop the asymmetric information case and we contrast it to the benchmark
in order to establish our main result (which we illustrate through a numer-
ical example); in Section 5, we reconsider the analysis introducing outside
options; we conclude in Section 6.
2Themodel
Suppose a single seller oers a product to a unit mass of buyers. The seller’s
opportunity cost is cs,wheres{L, H}is the quality of the product. High
quality is assumed to be more costly than low quality, cH>c
L.There
is a unit mass of buyers who are assumed to be identical and have unit
demand. The valuation of each buyer is assumed to be rs.Bydenition,
high quality is more valuable than low quality, rH>r
L.DenoteI(λ)the
investment that is needed to obtain that with probability λthe product is of
high quality. We view this investment as a commitment to meet on average
a certain reliability of the product. Suppose that I(λ)=(k/2)λ2,which
satises I0>0,I00 >0,andlimλ0I0(λ)=0. As stated in the introduction,
I(λ)can be interpreted as eorts to meet standards for quality management
systems.
We consider the following three-stage game: at stage 1, the rm invests I
in quality; at stage 2, after learning the quality realization it sets its price; at
stage 3, buyers form beliefs about product quality and make their purchasing
decision. As we will explore below, under full information the rm chooses
a strictly positive investment level if rHcH>r
LcLand zero investment
if the reverse inequality holds. Note that in our setting the full-information
solution implements the rstbestallocation(thisisduetothefactthatthe
rm fully extracts all surplus); thus deviations from the rstbestarethe
result of asymmetric information.
If the quality choice and the underlying investment decision cannot be
observed by consumers, the rm has no means to convince consumers that its
4
product is of high quality; the rm will therefore invest zero. This conrms
that in markets in which rms choose quality, rms tend to provide too low
a quality from a social point of view.
What we investigate is whether a risky investment in quality, where the
investment is observable to consumers, results in the same type of quality
trap as before. Clearly, the situation we envisage now potentially allows
consumers to obtain information about the expected quality in the market,
since consumers observe the investment eort and have a clear understanding
of the relationship between investment spending and expected quality. We
assume that the high quality is socially benecial, i.e. rH>c
H.Wemake
no such assumption for the low quality; rather, we want to contrast the
cases where the low quality is either socially benecial (rL>c
L)ornot
(rL<c
L). To simplify the exposition, and with minimum loss of generality,
we also assume that the high quality is socially more benecial than the low
quality, rHcH>r
LcL(which is trivially satised when the low quality
is not socially benecial). We restict attention to equilibria in which the
rm extracts all rents so that price is equal to expected surplus.5
3 Full information benchmark
We rst analyze the full information case (i.e., consumers observe the in-
vestment and the realization of quality). We distinguish between two cases:
(1) rL>c
Lso that under full information also low quality is put on the
market and (2) rL<c
Lso that under full information low quality is not put
on the market.
In case (1), the rm’s maximization problem is maxλ1=λ(rH
cH)+(1λ)(rLcL)(k/2)λ2.Solvingtherst-order condition of prot
maximization, we obtain as the probability for high-quality: (rHcH
rL+cL)/k. Notethatwehaveaninteriorsolutionifk>r
HcHrL+cL
(otherwise the probability is 1).6We al so check th a t the rm’s expected
5In a modied model in which the number of consumers exceeds the number of available
units and in which consumers bid for the product, equilibrium price is necessarily equal
to expected surplus (see e.g. Tadelis, 1999).
6From our assumption that rHcH>r
LcL, the probability is necessarily strictly
5
prot evaluated at λ=(rHcHrL+cL)/k is positive:
1|λ=(rHcHrL+cL)/k =1
2k(rHcHrL+cL)2+(rLcL)>0(1)
In sum, the probability for high quality under full information in case (1) is
λf
1=(1
k[(rHcH)(rLcL)] if k>r
HcHrL+cLk0,
1if kk0.(2)
In case (2), the rm’s problem is maxλ2=λ(rHcH)(k/2)λ2,
which yields the following prot-maximizing probability for high-quality:
(rHcH)/k > 0. Notethatwehaveaninteriorsolutionaslongask>
rHcH(otherwise the probability is 1)andthattherm’s expected prot
evaluated at λ=(rHcH)/k is positive. We can then dene the probability
for high quality under full information in case (2) as
λf
2(1
k(rHcH)if k>r
HcHk1,
1if kk1.(3)
4 Asymmetric information
Consider now the situation of asymmetric information in which consumers
observe Ibut not the realization of quality. We analyze perfect Bayesian
equilibria of the game in which the rm observes quality after stage 1 and
consumers only observe the investment level (and price) but not the realized
quality. We start with the situation where consumers expect any quality
realization to be put on the market (clearly, if high quality is put on the
market, so is low quality since its costs are lower). The expected surplus is
thus λrH+(1λ)rL, which is the price the rm will set at stage 2. Hence,
expected prots at stage 1 are
λ[λrH+(1λ)rLcH]+(1λ)[λrH+(1λ)rLcL](k/2)λ2
=λ(rHcH)+(1λ)(rLcL)(k/2)λ2.
Solving the rst-order condition of prot maximization, we obtain as the
probability for high-quality:
λa1
k(rHcHrL+cL).(4)
positive.
6
As we have seen above, λa<1provided that k>k
0. Moreover, from
expression (1), we know that the rm’s expected protevaluatedatλ=λa
is positive in case (1) but might be negative in case (2) as rLcL<0.
Therefore, in case (2), the rm is better oby entering the market than not
being active as long as λa(rHcH)+(1λa)(rLcL)(k/2) (λa)2>0,or
k<(rHcHrL+cL)2
2(cLrL)k2.
Itiseasilycheckedthatincase(2),k1<k
0<k
2.
Comparing expression (4) with expressions (2) and (3), we observe that,
when consumers expect both qualities to be put on the market, the proba-
bility for high-quality is weakly greater under asymmetric information than
under full information. Investment incentives are not aected by consumer
information if rLcL(λa=λf
1) but are stronger under asymmetric in-
formation if the reverse inequality holds. Indeed, in the latter case, we
observe that low-quality products are not released on the market under full
information, but that low quality is always consumed under asymmetric in-
formation. Since this expected lower quality is reected in price and since
low quality is produced at costs above the consumers’ willingness to pay,
the rm has an incentive to reduce the probability of low quality products
through higher investments. It is only when the investment cost is very high
(i.e., k>k
2)thattherm prefers not to invest under asymmetric informa-
tion while it keeps on investing under full information. The results for case
(2) are summarized in the following table (where λa
2denotes the probability
of high quality under asymmetric information in case (2)).
kk1k1<kk0k0<kk2k>k
2
λa
2=λf
2=1 λa
2=1
f
2λa
2=λa
f
2λa
2=0
f
2
The previous results were derived under the assumption that a high qual-
ity product stays in the market under asymmetric information. However,
at stage 2, the rm may not be interested in oering high quality on the
market, while it is always willing to do so under full information (under
our assumption that rH>c
H). For a high-quality rm to make positive
operating prots, the price must exceed costs, i.e. λrH+(1λ)rLcH0,
7
which is equivalent to
λe
λcHrL
rHrL
.
Hence, the rm will indeed implement λaif λae
λ, which can be rewritten
as
λae
λ⇐⇒ krHrL
cHrL
(rHcHrL+cL)k3.
If k>k
3and the rm implemented λa, consumers would know that a
high-quality rm would not participate, so that their beliefs about product
quality would not be conrmed. Consumers expect a suciently high prob-
ability that the product is of low-quality, which reduces their willingness to
pay. Hence, the rm cannot charge a suciently high price to cover its cost
in case it is of high quality. In such a case (i.e., λa<e
λor k>k
3), the
rm has the option to increase its investment expenditure, so as to increase
the probability of high quality up to e
λ. The condition for this option to be
protable for the rm diers according to whether we are in case (1) or in
case (2).
In case (1), as rL>c
L,therm may alternatively invest zero and oer
low quality on the market. The former action is more protable than the
latter if e
λ(rHcH)+(1e
λ)(rLcL)(k/2)e
λ2>r
LcLor, equivalently,
e
λ[(rHcH)(rLcL)] (k/2)e
λ2>0.Solvingforkwe must have k<
2[(rHcH)(rLcL)]/e
λ,whichis
k<2rHrL
cHrL
[(rHcH)(rLcL)] = 2k3.
Noting that k3>k
0(since, by assumption rH>c
H), we now have a com-
plete picture of the probability of high quality in case (1) under asymmetric
information. We contrast it with the solution under full information in the
following table:
kk0k0<kk3k3<k2k32k3<k
λa
1=λf
1=1 λa
1=λf
1<1λa
1
f
1λa
1=0
f
1
In case (2), with rL<c
L, overinvestment is protable if e
λ(rHcH)+
(1 e
λ)(rLcL)(k/2)e
λ2>0, which is equivalent to
k<2(rHrL)(cHcL)(rHcH)
(cHrL)2k4.
8
Summarizing our previous ndings, we have that the probability of high
quality under asymmetric information in case (2), λa
2,isequaltoλaas long
as (i) k>k
0(otherwise, it is equal to 1), (ii) k<k
2(otherwise, it is equal to
0), and (iii) k<k
3. If the latter condition is not met, the rm will increase
the probability of high quality up to e
λas long as k<k
4. To get a complete
picture, we need to rank the thresholds k0,k1,k2,k3and k4.Wedetailthis
ranking in the appendix, which allows us to state the following proposition,
wherewedene
≡−
(cHrL)(rHcH)
(2rHcHrL).
Proposition 1 If consumers observe investments in the quality of products
but not the quality itself, a rm invests strictly more in quality under asym-
metric information than under full information, provided that (1) rLcL>0
and k3<k2k3or (2a) <r
LcL<0and k1<kk4,or(2b)
rLcL<and k1<kk2.
The three situations of over-investment are depicted in Figure 1. To
get the intuition behind our result, let us restate the two arguments. First,
we have seen that ignoring the participation constraint of the high-quality
rm, investment incentives weakly increase under asymmetric information
compared to full information. The reason for the potential overinvestment
is that a low-quality rm stays in the market under asymmetric information
even though its value is less than the cost because it is sold at the expected
and not the actual value. The fact that the product may be of low quality is
takenintoaccountbyconsumersandthusreected in the price. Therefore,
by investing more, the rm can convince consumers that the risk of obtain-
ing low quality is reduced. Secondly, taking into account the participation
constraint of a high-quality rm, investments under given beliefs may be
insucient to make selling high quality worthwhile. This implies that λa
cannot be the equilibrium belief at the investment level I(λa).Tomake
the participation of the high-quality rm worthwhile, the rm has to distort
its investment upward in order to convince consumers that a high-quality
outcome is more likely, in which case they are willing to pay more. Thirdly,
at the investment stage the rm has to compare prots with such an upward
distorted investment to the outside option (which is either zero or to sell low
9
rL
k3
k1
2k3
k0
k
cL
rL<cL+
k4
k2
rH-cH+cL
2b
1
2a
Figure 1: Overinvestment under asymmetric information
quality). It may be protable to overinvest. It is only when investments are
too costly (i.e. k>2k3for rL>c
Lor k>k
2or k4for rL<c
L)thatthe
standard underinvestment result under asymmetric information holds.
Anumerical example (which gives parameter values to all parameters ex-
cept k) illustrates our results for cases (1) and (2a). Take rH=10,cH=6,
and cL=2. WetaketwovaluesforrL:eitherrL=3>c
L(case (1))
or rL=1<c
L(case (2a)). Consider rst case (1) with rL=3. Under
full information, the rm would choose its investment such that λf
1=3/k.
As we have seen above, under asymmetric information and provided that
consumers expect that products are sold on the market independent of the
realization of the random variable, the rm would invest such that λa=λf
1.
However, for a high-quality rm to make positive operating prots the price
must exceed costs, i.e. λrH+(1λ)rLcH0, which becomes λe
λ3/7
10
under our parameter values. Hence, the rm will indeed implement λaif
λae
λ. Otherwise, if the rm implemented λa, consumers would know
that a high-quality rm would not participate so that their beliefs about
product quality would not be conrmed. Consumers expect a suciently
high probability that the product is of low-quality which reduces their will-
ingness to pay. Hence, the rm cannot charge a suciently high price to
cover its cost in case it is of high quality. The rmcanthenincreaseits
investment expenditure to increase the probability of high quality. Expected
quality is higher than under full information if e
λ=3/7>3/k =λf
1,which
is equivalent to k>k
3=7. To be an equilibrium strategy also at the
investment stage, expected prots must be greater than rLcL=1,i.e.
4λ+(1λ)(k/2)λ21.Evaluatedat
e
λ=3/7,thisisequivalentto
k2k3=14. Hence, for parameter values k(7,14] the rm invests
strictly more under asymmetric than under full information.
Suppose now that rL=1,sothatweareincase(2a). Wecheckthat
cLrL=1<=20/13,sothatk2>k
3. Under full information, the rm
would choose its investment such that λf
2=4/k. Hence, k1=4. Redoing the
computations under asymmetric information, we nd that k0=5,k3=9,
k4'11.5and k2=12.5. Take, e.g., k=10and compute the various
thresholds on λ:7
e
λ=5
9
a=1
2
f
2=2
5.
Hence, for parameter values k(4,11.5] the rm invests strictly more
under asymmetric information than under full information. For an interme-
diate range of investment cost levels (k(9,11.5))therm has to further
increase its investment in order to convince consumers that a high-quality
product will be put on the market. Only if investment costs are too high
(k>11.5), investment under asymmetric information breaks down to zero
and is therefore less than under full information. Figure 2 illustrates our
results in case (2a), where rL<c
L.8
7We have checked that expected prots at stage 1 under h
λare positive (namely, h
λ(rH
cH)+(1h
λ)(rLcL)(k/2)h
λ2=19/81).
8Although the rm invests more under asymmetric information, it can easily be checked
that it always makes at least as much prots under full information than under asymmetric
information.
11
λa
λf
λ
1
λ
~
k3k4k
k1 k0
Figure 2: Investment in quality in case (2a)
5 The analysis with outside options
Our analysis can be criticized for the fact that under asymmetric informa-
tion, high quality is less protable than low quality since both are sold at
the same price, while low quality is cheaper to produce. If a successful in-
vestment enables the rm not only to produce high but also low quality, the
rm will always deviate to low quality due to the moral hazard problem.
This in turn would imply that a rm does not have any incentive to invest
under high quality because a higher investment does not contain information
about the expected product quality that will be put on the market. How-
ever, if the production cost of high and low quality is the same whereas high
and low quality give dierent values for an outside option, a high quality
rm does not have an incentive to deviate to low quality (provided that its
production costs do not increase in quality).9We can then show that our
qualitative ndings from above are conrmed.
Let vHand vLdenote the value of the outside option for high and low
quality, respectively, while cdenotes the production cost which is indepen-
9We can think of the outside option as a costly action taken by the rm; in particular,
it may use the services of a third-party certifyer, who certies realized product quality (on
the logic of third-party certication, see e.g. Biglaiser, 1993). If this action fully reveals
its product quality the rm can sell high quality under full information at a price vH.In
particular, rHvHconstitutes the cost of certication.
12
dent of quality. By the nature of the problem, rH>v
H>v
L. In addition,
we assume that the value of the outside option for high quality exceeds pro-
duction costs, vH>c. We can then replicate the analysis of Section 3. First,
we obtain the probability for high quality under full information as
λf(1
k(rHc)if rL<c,
1
k(rHrL)if rLc,
and we dene ˆ
k0rHc. Next, we turn to the analysis under asymmetric
information and consider rst the case rLc. In analogy to Section 4, we
obtain that ˆ
λa=(1/k)(rHrL)and b
˜
λ=(vHrL)/(rHrL),wherethe
latter expression comes from the condition that the price λrH+(1λ)rL
has to exceed the value of the outside option for a high-quality product vH.
We then can calculate the critical value of kabove which overinvestment
with b
˜
λ>ˆ
λamay be required to solve the adverse selection problem:
ˆ
k3=(rHrL)2
vHrL
.
For an investment I(λ)with λˆ
λato be worthwhile we must have that
the prot is non-negative for rL<c. We obtain that this is the case for all
kˆ
k2where
ˆ
k2=(rHrL)2
2(crL),
which is always greater than ˆ
k0. Hence, the non-negativity condition is not
binding for all kˆ
k3if ˆ
k2>ˆ
k3.ThisisequivalenttovH+rL>2c.
Consider now k>ˆ
k3.ForrL>c,anupwarddistortionoftheinvest-
ment gives greater protthanoering low quality in the market at zero
investment, i.e. λrH+(1λ)rLc(k/2)λ2>r
Lc,aslongask<2ˆ
k3.
For rLc, an upward distortion of the investment gives greater prot
than being inactive with zero investment, i.e. λrH+(1λ)rLc(k/2)λ2>
0,aslongask<ˆ
k4where10
ˆ
k4=2vHc
vHrL
(rHrL)2
vHrL
.
10The inequality can be rewritten as 2[λ(rHrL)+rLc]2>k.Toobtain
ˆ
k4,we
substitute the expression for e
˜
λ. Clearly, ˆ
k4>ˆ
k3is equivalent to (vH+rL)/2>cbecause
in this case prots at ˆ
λaare strictly positive, so that an upward distortion that solves the
adverse selection problem is worthwhile.
13
We thus obtain the following result:
Proposition 2 Suppose that a successful investment allows the rm to choose
between high and low quality, which are produced at equal cost, but that high
quality has a higher value than an outside option. If consumers observe in-
vestments in the reliability of products but not reliability itself, a rm invests
strictly more in reliability (or quality) under asymmetric information than
under full information, provided that (1) rL>cand ˆ
k3<kˆ
k4,or(2)
rL<cand ˆ
k0<kmax nˆ
k2,ˆ
k3o.
6Conclusion
We have provided a counter-example to the belief that asymmetric informa-
tion about product quality reduces the incentives to provide higher quality;
we have shown that the reverse may actually be true. It obtains in situations
where rms have the possibility to make a risky and observable investment
to increase the average quality (reliability) of their products. An example of
such investments could be the eort to obtain the ISO 9000 certication for
the rm’s quality management system. Although consumers do not observe
the realization of quality, they observe how much the rm has invested and,
thereby, infer useful information about the expected quality on the market.
Knowing this, a rm producing high quality may overinvest in the quality or
reliability of its product to convince consumers that high quality is indeed
very likely to be put on the market; this avoids the lemons problem and
thus may be the rm’s optimal strategy. Also, if selling low quality has a
negative social value, the rm may want to reduce the probability of low
quality realization compared to the full-information world, because under
full information low quality would not be put on the market, whereas in an
adverse selection environment low quality is always oered. We have thus
identied two simple reasons for overinvestment in quality under asymmetric
information.
14
7 Appendix. ProofofProposition1
Most of the proof is in the main text. The missing part concerns the ranking
of the thresholds k0to k4in case (2). We already know that k3>k
0.Afew
lines of computation establish that
k3>k
2⇐⇒ rLcL<(cHrL)(rHcH)
(2rHcHrL),
k2k4=(rLrH2cLrHr2
L+rLcL+rHcHc2
H+cLcH)2
2(cLrL)(cHrL)2>0,
k2k3
k4k3=(rHcHrL+cL)(cHrL)
2(rHrL)(cLrL)>0.
(Note that the last two inequalities hold because we are in case (2) where
cL>r
L). We need then to distinguish among two cases.
1. If k2<k
3, then the rm prefers to exit the market (k>k
2)before
λabecomes inferior to e
λ(k>k
3). Then, if k0<k
2,wehavethat
λa
2=1for kk0,λa
2=λafor k0<kk2and λa
2=0for k>k
2;
otherwise, if k0>k
2,wehavethatλa
2=1for kk2and λa
2=0
for k>k
2. Comparing with expression (3) and recalling that (i)
k0,k
2>k
1and (ii) λa
f
2for k>k
1,wehavethatinbothcases,the
rm invests strictly more under asymmetric information than under
full information if k1<kk2.
2. If k2>k
3,wealsohavethatk4>k
3(as k2k3and k4k3have
the same sign). Then, λa
2=1for kk0,λa
2=λafor k0<kk3,
λa
2=e
λfor k3<kk4and λa
2=0for k>k
4. It follows that the
rm invests strictly more under asymmetric information than under
full information if k1<kk4.
References
[1] Akerlof, George (1970), The Market for Lemons: Qualitative Uncer-
tainty and the Market Mechanism, Quarterly Journal of Economics
84, 488—500.
15
[2] Anderson, Shannon W., J. Daniel Daly and Marilyn F. Johnson (1999),
Why Firms Seek ISO 9000 Certication: Regulatory Compliance or
Competitive Advantage? Production and Operations Management 8,
28—43.
[3] Biglaiser, Gary (1993), Middlemen as Experts, Rand Journal of Eco-
nomics 24, 212—223.
[4] Cole, Robert E. (1998), Learning from the Quality Movement: What
Did and What Didn’t Happen? California Management Review 41,
43—73.
[5] Creane, Anthony (2006), Latent Adverse Selection, mimeo.
[6] de Meza, David and David C. Webb (1987), Too Much Investment: A
Problem of Asymmetric Information, Quarterly Journal of Economics
102, 281—292.
[7] Leland, Hayne E. (1979), Quacks, Lemons, and Licensing: A Theory of
Minimum Quality Standards, Journal of Political Economy 87, 1328—
1346.
[8] Lensink, Robert and Elmer Sterken (2001), Asymmetric Information,
Option to Wait to Invest and the Optimal Level of Investment, Journal
of Public Economics 79, 365—374.
[9] Milgrom, Paul and John Roberts (1986), Price and Advertising Signals
of Product Quality, Journal of Political Economy 94, 796—821.
[10] Nelson, Philip (1974), Advertising as Information, Journal of Political
Economy 82, 729—54.
[11] Shieh, Shiou (1993), Incentives for Cost-Reducing Investment in a Sig-
nalling Model of Product Quality, Rand Journal of Economics 24, 466—
477.
[12] Tadelis, Steven (1999), What’s in a Name? Reputation as a Tradeable
Asset, American Economic Review 89, 548—563.
16
... The point of departure for analysing investment readiness level (IRL) is principal-agency theory (Jensen and Meckling, 1979;Farrell, 2003;Ryan and Schneider, 2003;Kaplan and Strömberg, 2003;Singla et al., 2014). The information asymmetry between entrepreneurs and financiers represents an obstacle for small and medium sized companies (SMEs) when seeking for alternative sources of finance (Schmid, 2001;Hsu, 2007;Subhash, 2009), together with other parameters of investment decisionmaking including attitudes towards alternative sources of finance (Strebulaev et al., 2014;Belleflamme and Peitz, 2014). To reduce the number of obstacles and resolve the difficulty of moral hazard, greater interaction between entrepreneurs and investors is called for (Sjögren and Zackrisson, 2005;Southon and West, 2006;Dehlen et al., 2014). ...
Article
Full-text available
This contribution outlines the rising and promising research topic related to investment readiness level (IRL) of Small and Medium Sized Companies (SMEs). To advance this field of investigation and to bring potential future research directions to light, this paper reviews and explores the current state of research by means of a literature review contemplating quantitative facets in the methodology. While facilitating comparisons in applied methods of earlier development and progress, it uncovers core areas where research is still required. By considering the present body of literature focusing on the IRL of SMEs as a whole, this paper ends by proposing two essential recommendations for future research effort. The paper captures the multi-faceted nature of IRL to reveal the range of conditions of alternative financial sources affecting the activities of researchers, entrepreneurs, investors and politicians alike.
... More importantly, the heterogeneity in consumers claiming cost provides multiple strategies to the firm, modifying the incentives to provide reliability. Belleflamme and Peitz (2007) show that firms may have incentives to overprovide product reliability when investments to improve product reliability are observable and provide a signal of unobservable product quality. Our result, instead, applies even when product reliability is observable, introducing a direct new mechanism that leads to overprovision of product reliabilty. ...
Article
In their dealings with retailers and suppliers, regulations and warranties ensure that consumers can seek a repair, a replacement or a refund if the good they have purchased is faulty. The evidence, however, indicates that few consumers pursue any form of compensation, suggesting that, for some consumers, transaction costs are high and providing a rationale for the role that consumers' associa-tions play. In this article, we analyze the monopolist's pricing and product reliability problem when consumers are entitled to product replacement but have heterogeneous cost of exercising this right, and we assess the implications of a decrease in consumers' claiming costs. In this environment, the firm increases product reliability to increase consumers' willingness to pay and to reduce the ex-pected number of complaints. As consumers claiming cost decreases, the number of complaints and the consumer surplus increase. If this effect is sufficiently high, the firm can partially appropriate the surplus that consumers derive from replacing defected units by increasing its price. However, as consumers claiming cost decreases, the effect of product reliability on consumer willingness to pay diminishes, and, thus, product reliability may decrease. Surprisingly, consumers complaints may reduce product reliability. Our results, that are robust to different specifications, help to explain why some firms help and some others discourage consumers from complaining. Our simple model also shows that firms have incentives to overprovide product reliability. Finally, our results have several suggestions and policy implications.
Article
Full-text available
The current unemployment insurance and employment protection legislation were set up in an environment in which relationships between workers and firms were typically long-lasting and stable. The increasing globalisation of the economy and the rapid technological and organisational changes require more flexibility leading to career paths which are much more volatile both within and between firms. Current institutions must be therefore urgently reformed to reconcile this new need of more flexibility with that of security for workers. Rather than proposing a reform on the basis of existing institutions abroad, we propose a reform that is explicitly guided by economic principles.
Article
Full-text available
There is a striking disjunction between the views of many academics who believe the quality movement has sunk without a trace and practitioners who believe that they basically mastered the secrets of quality improvement. This article traces the path by which large American manufacturing firms came to terms with the Japanese quality challenge of the early 1980s. It explores both the barriers that delayed effective responses as well as the nature of the emergent infrastructure that eventually facilitated sustained quality improvement. The legacy of the quality movement is more than its detractors allow but less than its zealots proclaimed.
Article
Full-text available
In many applications,assumptions about the log-concavity of a probability distribution allow just enough special structure to yield a workable theory.This paper catalogs a series of theorems relating log-concavity and/or log-convexity of probability density functions,distribution functions,reliability functions,and their integrals. We list a large number of commonly-used probability distributions and report the log-concavity or log-convexity of their density functions and their integrals. We also discuss a variety of applications of log-concavity that have appeared in the literature. (The current draft corrects a typo in Table 3.)
Article
Full-text available
I consider markets with asymmetric information. As suggested by Akerlof, quality deterioration in such markets may take place. I show that this is a general phenomenon. Minimum quality constraints (or "licensing requirements") are examined as a possible solution to the problem. Although not generally a first-best solution, such constraints will increase welfare in a number of cases. The types of markets that are likely to benefit from minimum quality standards are identified. It is then shown that, if quality standards are set by the profession (or industry) itself, it is likely that the standards will be too high.
Article
This paper relates quality and uncertainty. The existence of goods of many grades poses interesting and important problems for the theory of markets. On the one hand, the interaction of quality differences and uncertainty may explain important institutions of the labor market. On the other hand, this paper presents a struggling attempt to give structure to the statement: “Business in under-developed countries is difficult”; in particular, a structure is given for determining the economic costs of dishonesty. Additional applications of the theory include comments on the structure of money markets, on the notion of “insurability,” on the liquidity of durables, and on brand-name goods.
Article
This paper analyzes equilibrium rationing on credit markets in the case of gains from waiting to acquire information about the future profitability of investment. We compare the competitive outcome with the socially optimal level of investment. We show that the opportunity to postpone investment changes the nature of the inefficiencies of the competitive outcome fundamentally. Without the option to wait, high risk firms tend to invest and the outcome is characterized by a situation of underinvestment. If firms can wait high risk firms benefit the most from waiting. In this case low risk firms tend to invest immediately and a situation of overinvestment will result, since from the banks’ point of view firms do not delay enough.
Article
The conditions under which transactors can use the market (repeat-purchase) mechanism of contract enforcement are examined. Increased price is shown to be a means of assuring contractual performance. A necessary and sufficient condition for performance is the existence of price sufficiently above salvageable production costs so that the nonperforming firm loses a discounted steam of rents on future sales which is greater than the wealth increase from nonperformance. This will generally imply a market price greater than the perfectly competitive price and rationalize investments in firm-specific assets. Advertising investments thereby become a positive indicator of likely performance.
Article
This paper tries to show how the major features of the behavior of advertising can be explained by advertising's information function. For search qualities advertising provides direct information about the characteristics of a brand. For experience qualities the most important information conveyed by advertising is simply that the brand advertises. This contrast in advertising by these qualities leads to significant differences in its behavior. How does advertising provide information to the consumer? The producer in his advertising is not interested directly in providing information for consumers. He is interested in selling more of his product. Subject to a few constraints, the advertising message says anything the seller of a brand wishes. A mechanism is required to make the selling job of advertising generate information to the consumer. [Авторский текст]
Article
This chapter discusses job market signaling. The term market signaling is not exactly a part of the well-defined, technical vocabulary of the economist. The chapter presents a model in which signaling is implicitly defined and explains its usefulness. In most job markets, the employer is not sure of the productive capabilities of an individual at the time he hires him. The fact that it takes time to learn an individual's productive capabilities means that hiring is an investment decision. On the basis of previous experience in the market, the employer has conditional probability assessments over productive capacity with various combinations of signals and indices. This chapter presents an introduction to Spence's more extensive analysis of market signaling.
Article
I. Introduction, 488. — II. The model with automobiles as an example, 489. — III. Examples and applications, 492. — IV. Counteracting institutions, 499. — V. Conclusion, 500.