Certifying Firms

Abstract

I study the design of dynamic certification schemes for firms that are privately informed about their competence and their efforts towards quality provision. I identify the certifier's tension between disclosing firms' track records to consumers and providing effort incentives to firms, and show that a low-standard honors scheme resolves the tension and maximizes the certifier's revenue: at each time, competent firms are either "certified" or "certified with honors"; inept firms are always "certified." Such scheme maximizes competent firms' effort incentives and also maximizes social surplus. I relate my findings to concerns about certification in practice.

Keywords: certification, adverse selection, dynamic moral hazard

JEL Classification: C72, C73, D82, D83, M52, G24