Imperfect Quality Certification in Lemons Markets

Ashutosh Prasad,Birendra K Mishra,Vijay Mahajan

doi:10.4236/tel.2020.106077

Abstract

In markets with information asymmetry, the seller of a high-quality product is unable to credibly communicate its quality to buyers and is forced to price like an average quality seller. This is a disincentive to provide quality and high-quality sellers may exit the market. Of several methods to reduce information asymmetry, we provide an analytical study of certification or grading of quality levels by infomediaries. In the equilibrium of a quality reporting game, we find that certification reduces, but does not eliminate, the problems of information asymmetry. There exists a threshold, determined by the accuracy of the certification process, below which customers should believe quality reports, but disbelieve reports above it. We further examine a two-category scheme of high/low quality certification and discuss the design of certification grades using an entropy approach.

Highlights

There are many markets in which sellers know the quality of their products but potential buyers do not, unless they buy the product and experience it
Of several methods to reduce information asymmetry, we provide an analytical study of certification or grading of quality levels by infomediaries
This paper examined the use of an imperfect certifier to resolve the information asymmetry between the buyers and seller

Summary

Introduction

There are many markets in which sellers know the quality of their products but potential buyers do not, unless they buy the product and experience it. In this paper we look at an imperfect quality certification game between the buyer, seller and third party. The seller reports its quality and provides a product sample or other requested information to the third party and asks it to certify its report. We focus on the scenario, termed report verification, where the seller hires the third party to certify its quality claims. The ensuing detailed examination reveals the true quality and R = q This commonly used type of certification, called report verification, is used by auditors (Newman, Rhoades, & Smith, 1996) and taxation authorities (Reinganum & Wilde, 1986) among others. ( ) where E [⋅] is the expectation operator and b q | Ris the buyer’s belief about the quality of the product conditional on observing R (note that the buyer does not observe R)

Findings

Analysis and Discussion

Conclusion