Who Should Pay for Certification?

Many markets are characterized by a fundamental informational asymmetry: the seller of a product knows better its quality than the buyer. Also in many markets, the seller cannot credibly communicate the quality of his product to the buyer. In the extreme, he cannot sell, without certification, the high quality product at a price above the cost of producing it, and thus will end up not producing high quality. In this situation, in order for the market to function efficiently, an independent certifier is called for who truthfully ascertains the quality of the product. However, also the buyer is in need of certification. Imagine that she is confronted with a high price: He then does not want to be cheated by buying a low quality product, if that high price is inadequate. A priori, it is not clear whether certification is more valuable: to the seller or to the buyer. In this paper, we therefore ask the simple but essential question: Who does, and who should, from a general welfare point of view, initiate certification in a bilateral trading situation, the seller or the buyer? One might be tempted to react to that question by saying: It does not matter. But we show that it does. Indeed, certification is induced by two sides of the market in very different circumstances. The seller, as the better informed party, only asks for certification when he indeed produces a high quality product. By contrast, the buyer asks for certification when confronted by a high price, and eventually waists money in all cases where the seller wants to cheat the buyer by charging a high price for a low quality good. In this case the buyer does not accept the good at the quoted price if certified as not of high quality. In all, within the theoretical model developed here, we give a very clear answer to our questions: As long as certification is truthful, it is, and it should be, the seller who initiates the certification process. The reason is that he does so only when the good is of high quality. We also show that the argument is robust to a number of generalizations, in particular imperfect certification, more complex pricing schemes, or a many buyer-one seller situation.

Stahl, Konrad and Roland Strausz (2011), Who Should Pay for Certification?, ZEW Discussion Paper No. 11-054, Mannheim.