This paper analyzes bilateral contracting in an environment with contractual incompleteness
and asymmetric information. One party (the seller) makes an unverifiable
quality choice and the other party (the buyer) has private information about its valuation.
A simple exit option contract, which allows the buyer to refuse trade, achieves
the first–best in the benchmark cases where either quality is verifiable or the buyer’s
valuation is public information. But, when unverifiable and asymmetric information
are combined, exit options induce inefficient pooling and lead to a particularly simple
contract. Inefficient pooling is unavoidable also under the most general form of contracts,
which make trade conditional on the exchange of messages between the parties.
Indeed, simple exit option contracts are optimal if random mechanisms are ruled out.
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