Informational Equilibrium.

by J. G. Riley

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If buyers are less well-informed about product quality than sellers, and no additional information is available, market clearing prices must reflect some weighted average of product quality. Then if potential sellers of the highest quality products have the greatest opportunity costs and these costs exceed price, they will not enter the market. This "adverse selection" phenomenon is, however, offset if sellers of higher quality products can adopt sales-related activities that operate as a "signal" to potential buyers. These "informational equilibria" in which signaling is needed to distinguish product quality do not have the stability properties of classical Walrasian equilibria. It is shown that if product quality varies continuously across sellers, there is no informationally consistent set of prices and signals that is a Nash equilibrium set. An alternative noncooperative equilibrium concept is introduced and defended as a plausible imperfectly competitive equilibrium. It is then demonstrated that among the many informationally consistent sets of price-signal pairs, there is a unique "reactive equilibrium." 49 pp. Ref.

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