IMPERFECT PRODUCT TESTING AND MARKET-SIZE

We consider an imperfect test of product quality, and ask how it interacts with adverse selection to affect market size. Although one might expect adverse selection to be mitigated, there are scenarios where it is exacerbated. Also, two counter-intuitive comparative static results emerge. First, a small increase in the test cost can increase the equilibrium expected profits earned by sellers of higher quality units, and so expand the market. Second, the equilibrium expected profits earned by sellers with lower quality units can be increased by a small improvement in the accuracy of an imperfect test.