CeDEx workshop - Matthias Dahm (University of Nottingham)

Credence Goods, Costly Diagnosis, and Subjective Evaluation

(joint with Helmut Bester, Freie Universität Berlin)

Abstract: We study contracting between a consumer and an expert. The expert can invest in diagnosis to obtain a noisy signal about whether a low--cost service is sufficient or whether a high--cost treatment is required to solve the consumer's problem. This involves moral hazard because diagnosis effort and signals are not observable. Treatments are contractible, but success or failure of the low--cost treatment is observed only by the consumer. Payments can therefore not depend on the objective outcome but only the consumer's report, or subjective evaluation. A failure of the low--cost treatment delays the solution of the consumer's problem by the high--cost treatment to a second period. We show that the first--best solution under perfect information can be contractually implemented for all parameter combinations if and only if the parties' discount rate is zero. In an extension we show that the first--best is always implementable if diagnosis and treatment can be separated by contracting with two different agents.