A dynamic model of certification and reputation

Markets typically have many ways of learning about quality, with two of the most important being reputational forces and certification, and these types of learning often interact with and influence each other. This paper is the first to consider markets where learning occurs through these different sources simultaneously, which allows us to investigate the rich interplay and dynamics that can arise. Our work offers four main insights: (1) Without certification, market learning through reputation alone can get “stuck” at inefficient levels and high-quality agents may get forced out of the market. (2) Certification “frees” the reputation of agents, allowing good agents to keep working even after an unfortunate string of bad signals. (3) Certification can be both beneficial and harmful from a social perspective, so a social planner must choose the certification scheme carefully. In particular, the market will tend to demand more certification than socially optimal because the market does not bear the certification costs. (4) Certification and reputational learning can act as complementary forces so that the social welfare produced by certification can be increased by faster information revelation. Copyright Springer-Verlag Berlin Heidelberg 2015