Imperfect Quality Certification in Lemons Markets

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.