Adverse Selection with Competitive Inspection

We develop a model with heterogeneous buyers and sellers in which the sellers have private information about their goods' qualities. We show that efficient trading cannot occur without middlemen. Middlemen can provide two services: one is inspection, and the other is the sorting of buyers and sellers through the rationing of sellers and the provision of two different price schedules. The latter service permits the possibility of achieving the first best. When the first best is not attainable, there is a second best characterized by two intervals, one consisting of low‐quality noninspected goods, and the other of high‐quality inspected goods. We determine whether first and second best outcomes can be implemented in a market equilibrium with both zero and infinite buyer‐seller search costs. First and second best outcomes are attainable under a larger set of parameter values when search costs are infinite; also, typically too much inspection occurs in a market equilibrium. Welfare may be either raised or lowered by the introduction of middlemen.