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CeDEx 2014-13: Credence Goods, Costly Diagnosis, and Subjective Evaluation (now forthcoming)

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Summary

Now forthcoming in Economic Journal.

In many situations, a consumer relies on the advice of an expert in order to choose a service that has important properties the consumer cannot detect even after consumption. Goods with this property are called credence goods and classical examples include medical and legal advice, and several types of repair services, among others. Even if the consumer can determine which service he received, he often does not know whether he really needed an expensive high quality service or whether a less costly service of lower quality would have been sufficient. This opens the door to opportunistic behaviour, because a self-interested expert who also provides the service might give inappropriate advice and remain undetected. As a result, the consumer might experience overtreatment: he receives an expensive service even though a less expensive service would have been sufficient. The inefficiencies that may arise in such a situation are potentially important, because overtreatment is considered an important reason for `waste’ and rising costs in health care.

In this Nottingham School of Economics working paper Bester and Dahm investigate the optimal design of contracts when the consumer needs one of two services and provide conditions under which the first-best can be reached. 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. This involves moral hazard because diagnosis effort and signals are not observable. Treatments are contractible, but only the consumer observes success or failure of the low-cost treatment. 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. Bester and Dahm show that the first-best solution can always be implemented if the parties' discount rate is zero; an increase in the discount rate reduces the range of parameter combinations for which the first-best can be obtained. In an extension, it is shown that the first-best is also always implementable if diagnosis and treatment can be separated by contracting with two different agents.

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CeDEx Discussion Paper 2014-13, Credence Goods, Costly Diagnosis, and Subjective Evaluation by Helmut Bester and Matthias Dahm, November 2014

Authors

Helmut Bester and Matthias Dahm

 

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Posted on Saturday 1st November 2014

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