Abstract
Abstract Moral hazard exists in expert‐service markets because sellers have an incentive to shade their reports of the buyer's condition to increase the short‐run demand for their services. The California vehicle emission inspection market offers a rare opportunity to examine how reputational incentives work in such a market. I show that consumers are 30 percent more likely to return to a firm at which they previously passed than to one at which they previously failed and that demand is sensitive to a firm's failure rate across all consumers. These and other results suggest that demand incentives are strong in this market because consumers believe that firms differ greatly in their consumer friendliness and are skeptical even about those they choose. Weak demand incentives in other expert‐service markets are not a direct consequence of moral hazard, but rather of its interaction with switching costs and consumers' belief that firms are relatively homogeneous.
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