Distribution of Price and Quality Under Information Asymmetry

Abstract

This paper presents a model in which firms compete for consumers who make repeat purchases of "experience" goods. Consumers can observe price offers of firms, even though they may not observe the quality before purchase. We set up a simple two-period model and find the following results. First, we identify the conditions for the equilibrium in which only one quality of firms can be observed in the market. The result shows that the lemons market problem is partially resolved. Second, the market may observe both quality dispersion as well as price dispersion in equilibrium. In such an equilibrium, the lemons are pooled with high quality firms, while the medium quality firms, if they exist, are separated from the pool. We find that the price of the pool is higher than the price of the medium quality firms. Third, we apply our analysis to insurance markets. We show how our results can be related to the insurance cycle, catastrophe insurance, and guaranty funds.