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Credible ratings

  • Damiano, Ettore

    ()

    (Department of Economics, University of Toronto)

  • Li, Hao

    ()

    (Department of Economics, University of Toronto)

  • Suen, Wing

    ()

    (School of Economics and Finance, University of Hong Kong)

This paper considers a model of a rating agency with multiple clients, in which each client has a separate market that forms a belief about the quality of the client after the agency issues a rating. When the clients are rated separately (individual rating), the credibility of a good rating in an inflationary equilibrium of the signaling game is limited by the incentive of the agency to exaggerate the quality of the client. In centralized rating, the agency rates all clients together and shares the rating information among all markets. This allows the agency to coordinate the ratings and achieve a higher average level of credibility for its good ratings than in individual rating. In decentralized rating, the ratings are again shared among all markets, but each client is rated by a self-interested rater of the agency with no access to the quality information of other clients. When the underlying qualities of the clients are correlated, decentralized rating leads to a smaller degree of rating inflation and hence a greater level of credibility than in individual rating. Comparing centralized rating with decentralized rating, we find that centralized rating dominates decentralized rating for the agency when the underlying qualities are weakly correlated, but the reverse holds when the qualities are strongly correlated.

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File URL: http://econtheory.org/ojs/index.php/te/article/viewFile/20080325/1985/105
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Article provided by Econometric Society in its journal Theoretical Economics.

Volume (Year): 3 (2008)
Issue (Month): 3 (September)
Pages:

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Handle: RePEc:the:publsh:370
Contact details of provider: Web page: http://econtheory.org

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  1. Archishman Chakraborty & Rick Harbaugh, 2004. "Comparative Cheap Talk," Working Papers 2004-08, Indiana University, Kelley School of Business, Department of Business Economics and Public Policy.
  2. Banks, Jeffrey S. & Sobel, Joel., 1985. "Equilibrium Selection in Signaling Games," Working Papers 565, California Institute of Technology, Division of the Humanities and Social Sciences.
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  9. Paul Milgrom & Robert J. Weber, 1981. "A Theory of Auctions and Competitive Bidding," Discussion Papers 447R, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  10. William Chan & Hao Li & Wing Suen, 2005. "A Signaling Theory of Grade Inflation," Working Papers tecipa-222, University of Toronto, Department of Economics.
  11. Mark N. Hertzendorf & Per Baltzer Overgaard, 2001. "Price Competition and Advertising Signals: Signaling by Competing Senders," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 10(4), pages 621-662, December.
  12. Karlin, Samuel & Rinott, Yosef, 1980. "Classes of orderings of measures and related correlation inequalities. I. Multivariate totally positive distributions," Journal of Multivariate Analysis, Elsevier, vol. 10(4), pages 467-498, December.
  13. Stephen Morris, 1999. "Political Correctness," Cowles Foundation Discussion Papers 1242, Cowles Foundation for Research in Economics, Yale University.
  14. Milgrom, Paul & Roberts, John, 1994. "Comparing Equilibria," American Economic Review, American Economic Association, vol. 84(3), pages 441-59, June.
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  16. Kyle Bagwell & Garey Ramey, 1991. "Oligopoly Limit Pricing," RAND Journal of Economics, The RAND Corporation, vol. 22(2), pages 155-172, Summer.
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