Asymmetric information and overinvestment in quality

- A higher investment level makes the realization of high quality more likely.
- Consumers observe the investment but not the realization of quality.
- Two reasons for which firm may overinvest in making high quality more likely.
- A sufficiently large investment can avoid adverse selection and reduce the probability of not socially valuable products in the market.

In a standard adverse selection world, asymmetric information about product quality leads to quality deterioration in the market. Suppose that a higher investment level makes the realization of high quality more likely. Then, if consumers observe the investment (but not the realization of product quality) before purchase, they can infer the probability distribution of high and low quality that may be put on the market. We uncover two effects that may lead the firm to overinvest in quality compared to a market with full information: first, an adverse selection effect according to which a sufficiently large investment can avoid adverse selection and, second, an efficiency effect according to which a larger investment reduces the probability of having in the market low quality products that are not socially valuable.