Dynamic Quality Signaling with Hidden Actions

Asymmetric information is an important source of inefficiency when an asset (such as a firm) is transacted. The two main sources of this asymmetry are the unobserved idiosyncratic characteristics of the asset (such as future profitability) and unobserved idiosyncratic choices (like secret price cuts). Buyers may use noisy signals (such as sales) in order to infer actions and characteristics. In this situation, does the seller prefer to release information fast or slowly? Is it incentive compatible? When the market is pessimistic, is it better to give up or keep signaling? We introduce hidden actions in a dynamic signaling model in order to answer these questions. Separation is found to be fast in equilibrium when sending highly informative signals is more efficient than sending lowly informative signals. When the market is pessimistic about the quality of the asset, depending on the cost structure, the seller either “gives-up” by stopping signaling, or the seller “rushes-out” by increasing the informativeness of the signal. We find that the unobservability of the action causes equilibrium effort to be too low and the seller to stop signaling too early. The model can be applied to education where grades depend on students’ effort, which is endogenously related to their skills.