Liability and reputation in credence goods markets

Abstract

This paper studies the impact of liability on a credence-good seller’s incentives to maintain a good reputation. Credence-good markets are characterized by information asymmetry about the value of sellers’ services to consumers who must rely on sellers for diagnosis and treatment provision. Liability refers to the legal environment in which the seller is liable for fixing consumers’ problems after charging them the price for his treatment. When the seller is short-lived, liability mitigates information asymmetry and facilitates trade. Nevertheless, liability may undermine a long-lived seller’s incentive to maintain a good reputation and reduces market efficiency.