Welfare effects of product certification under latent adverse selection

Abstract

Asymmetric information is a classic example of market failure that undermines the efficiency associated with perfectly competitive market outcomes, as goods or services are not always allocated to those who value them the most. Credible certification that substantiates unobservable characteristics of products that consumers value is a potential solution to such market failure. We examine the welfare effects of certification in markets in which asymmetric information induces a misallocation of goods, and compare the market equilibrium when the certification technology becomes available with the equilibrium without certification. We find that despite certification improving allocative efficiency, overall welfare may decrease when such certification is either only imperfectly accurate or costly to the firm (but not necessarily to society). Most of these findings are tied to the subtle interplay of consumer and producer decisions of self-selecting across two markets: certified and non-certified markets, as the self-selection has welfare implications in both markets.