Certifying Lemons

TL;DR

This paper analyzes how monopolistic certification affects market efficiency and welfare in environments with private information, highlighting conditions under which certification improves or worsens outcomes.

Contribution

It characterizes the equilibrium effects of a monopolistic certifier on information disclosure, welfare, and certificate design in adverse selection markets.

Findings

Certifier often pools different ability types, reducing information and welfare.

Precise certification can lead to perfect screening and improved welfare.

High standards can exclude low ability senders, affecting market participation.

Abstract

This paper examines an adverse selection environment where a sender with private information (high or low ability) tries to convince a receiver of having higher ability. Without commitment or costly signaling, market failure can occur. Certification intermediaries reduce these frictions by enabling signaling through hard information. This paper focuses on a monopolistic certifier and its impact on equilibrium welfare and certificate design. Key findings show that the certifier provides minimal information, pooling senders of varying abilities and leaving low rents for high type senders, which typically disadvantages the receiver. However, when precise information is demanded, the certifier screens the sender perfectly, benefiting the receiver. Thus, the monopolistic intermediary has an ambiguous effect on market efficiency. The results emphasize the importance of high certification standards, which drive low ability senders out of the market. Conditions for such equilibria are characterized, showing how simple threshold strategies by the receiver induce first-best outcomes. Additionally, the relationship between the characteristics of offered certificates and welfare is identified.