It is commonly observed that certification intermediaries mitigate informational asymmetries by “lending” reputational capital to support transacting parties’ quality commitments. However, this proposition is challenged by cases in which well-established intermediaries have failed to detect fraud, misrepresentation and other misbehavior. The “certification paradox” provides a more nuanced account that anticipates both the general success, and periodic failure, of certification intermediaries. Transacting parties minimize search and evaluation costs by using a small number of certification intermediaries with large stocks of reputational capital. Incumbent certifiers are substantially protected by entrants’ high costs of accumulating sufficient reputational capital and users’ high costs of switching to new certifiers. Incumbent certifiers have incentives to preserve reputational capital by generally maintaining investments in informational accuracy but, given the limited threats of competitive entry and user defection, to periodically save on costs by reducing certification effort. At least historically, certifiers have sought to commit against opportunistic reductions in informational accuracy by adopting non-profit, partnership and other “constrained” organizational forms that cap the gains from shirking on certification effort. This organizational prophylactic against certification failure may outperform direct regulatory interventions, which are liable to overestimate the demand for informational accuracy or erode the market rents that support certifiers’ incentives generally to maintain informational accuracy.
Banking and Finance Law | Business Organizations Law | Law | Law and Economics
Date of this Version
Jonathan M. Barnett, "The Certification Paradox" (July 2018). University of Southern California Legal Studies Working Paper Series. Working Paper 269.