Optimal Ratings and Market Outcomes

40 Pages Posted: 9 Sep 2019 Last revised: 23 Feb 2023

See all articles by Hugo A. Hopenhayn

Hugo A. Hopenhayn

University of California, Los Angeles (UCLA) - Department of Economics

Maryam Saeedi

Carnegie Mellon University - David A. Tepper School of Business

Date Written: September 2019

Abstract

This paper considers the design of an optimal rating system, in a market with adverse selection. We address two critical questions about rating design: First, given a number of categories, what are the criteria for setting the boundaries between them? Second, what are the gains from increasing the number of categories? A rating system helps reallocate sales from lower- to higher-quality producers, thus mitigating the problem of adverse selection. We focus on two main sources of market heterogeneity that determine the extent and effect of this reallocation: the distribution of firm qualities and the responsiveness of sellers' supply to prices. We provide a simple characterization for the optimal rating system as the solution to a standard k-means clustering problem, and discuss its connection to supply elasticity and the skewness of firm qualities. Our results show that a simple two-tier rating can achieve a large share of full information surplus. Additionally, we characterize the conflicting interests of consumers and producers in the design of a rating system.

Suggested Citation

Hopenhayn, Hugo A. and Saeedi, Maryam, Optimal Ratings and Market Outcomes (September 2019). NBER Working Paper No. w26221, Available at SSRN: https://ssrn.com/abstract=3450247

Hugo A. Hopenhayn (Contact Author)

University of California, Los Angeles (UCLA) - Department of Economics ( email )

Box 951477
Los Angeles, CA 90095-1477
United States

Maryam Saeedi

Carnegie Mellon University - David A. Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States

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