On Bilateral Trade with Interdependent Values

Abstract

We study a market for 'lemons' from the perspective of mechanism design in a bilateral trade setup. The closed-form solution for the seller-optimal safe mechanism under one-sided private information is provided. We show that a seller can disclose the quality of the goods by controlling the supply of her goods; high-quality sellers want their goods to be scarce and expensive and low-quality sellers abundant and cheap. In this way, sellers can differentiate their products from each other and maximize their payoffs. We extend this model to two-sided private information and give a novel characterization of the seller-optimal safe mechanism in this setup. It turns out that if there is two-sided asymmetric information, then the seller finds it optimal to engage in price signalling instead of quantity signaling. This is the least-cost way for the seller to signal her private information to the buyer.

Keywords: Informed Principal, Bilateral Trade, Mechanism Design, Interdependent Values

JEL Classification: D42, D82