Competition and Efficiency in Markets with Quality Uncertainty

This paper addresses the following question: Does competition enhance efficiency in markets with quality uncertainty? Using the mechanism design methodology, we characterize the maximal achievable level of efficiency in such markets, and then use this characterization to analyze how maximal efficiency varies with the degree of market competition. We show that the relationship between them is in general a non-trivial function of the main market parameters. In particular we show: (i) for some set of parameter values maximal efficiency is strictly increasing in the degree of market competition (although it never attains the first-best), but only until competition is sufficiently intense; thereafter, maximal efficiency is strictly decreasing in the degree of competition; (ii) for some set of parameter values maximal efficiency is strictly decreasing in the degree of market competition, attaining the first-best when there is no competition; and (iii) for some set of parameter values maximal efficiency is strictly increasing in the degree of market competition, attains the first-best once competition is sufficiently intense, and then remains at the first-best thereafter. JEL Classification Numbers: C7, D4, D61, D82. “. . . most cars traded will be the “lemons,” and good cars may not be traded at all. The “bad” cars tend to drive out the good (in much the same way that bad money drives out the good).” George A. Akerlof, The Market for “Lemons”: Quality Uncertainty and the Market Mechanism, 1970.