Dynamic Quality Signaling with Moral Hazard

42 Pages Posted: 5 Apr 2012 Last revised: 28 Jun 2012

Date Written: March 19, 2012

Abstract

Asymmetric information is an important source of inefficiency when assets (like firms) are transacted. The two main sources of this asymmetry are unobserved idiosyncratic characteristics of the asset (for example, quality) and unobserved idiosyncratic choices (actions done by the current owners). We introduce moral hazard in a dynamic signaling model where heterogeneous sellers exert effort to affect the distribution of a stochastic signal (for example sales or profits) of their firms. Buyers observe the signal history and make price offers to the sellers. High-quality sellers try to separate themselves from the less quality ones in order to receive high price offers, while the latter try to pool with the first group to avoid receiving a low price. We characterize the competitive equilibria of the model, and we propose an adaptation of existing refinements to the incorporation of moral hazard in dynamic signaling that implies uniqueness of equilibria. We find that similar individual characteristics across types of sellers make everyone worse off, since competition increases signaling waste. Also, due to the new intensive margin (effort), non-trivial signaling will take place even when the cost of signaling is large. In particular cases, we find analytical solutions, that allow transparent comparative statics analysis. The model can be applied to education where grades depend not only on the students’ skills, but also on their effort.

Keywords: Dynamic Signaling, Dynamic Moral Hazard, Endogenous Effort

JEL Classification: D82, D83, C73, J24

Suggested Citation

Dilme, Francesc, Dynamic Quality Signaling with Moral Hazard (March 19, 2012). PIER Working Paper No. 12-012, Available at SSRN: https://ssrn.com/abstract=2034393 or http://dx.doi.org/10.2139/ssrn.2034393

Francesc Dilme (Contact Author)

University of Bonn ( email )

Lennestrasse 35
53113 Bonn
Germany
0049228737957 (Phone)

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