Price Signaling and the Strategic Benefits of Price Rigidities

Abstract

We analyze trade between a price setting party (seller) who has private information about the quality of a good and a price taker (buyer) who may also have private information. Differently from most of the literature, we focus on the case in which, under full information, it would be inefficient to trade goods of poor quality. We show that there is a unique equilibrium outcome passing Cho and Kreps (1987) Never a Weak Best Response. The refined outcome is always characterized by absence of trade, although trade would be mutually beneficial in some state of nature. This occurs: 1. Even if the price taker has more precise information than the price setting party, and 2. Even when the information received by both parties is almost perfect. The model thus implies that signaling through prices may exacerbate the effect of adverse selection rather than mitigate it. The price setting party would always benefit from committing to prices that do not reveal her information. We develop this intuition by analyzing the strategic advantages generated by price rigidities. Possible applications to professional bodies and compensation policies are discussed.

Keywords: D4, D8, L15

JEL Classification: Market for Lemons, Signaling, Price Rigidities