Test Design and Minimum Standards

Test Design and Minimum Standards

By
Peter M. DeMarzo, Ilan Kremer, Andrej Skrzypacz
American Economic Review. June
2019, Vol. 109, Issue 6, Pages 2173-2207

We analyze test design and certification standards when an uninformed seller has the option to generate and disclose costly information regarding asset quality. We characterize equilibria by a minimum principle: the test and disclosure policy are chosen to minimize the asset’s value conditional on nondisclosure. Thus, when sellers choose the information provided, simple pass/fail certification tests are likely to dominate the market. A social planner could raise informational and allocative efficiency, and lower deadweight testing costs, by raising the certification standard. Monopolist certifiers also satisfy the minimum principle but set a higher standard and reduce testing rates to maximize revenue.