Efficient Labelling Policies for Credence Goods: Who Should Pay?

Transcription

1 Effcent Labellng Polces for Credence Goods: Who Should Pay? by Soham aks, and Pnak ose bstract We analyse optmal nformaton dsclosure polces nvolvng hdden attrbutes of credence goods when producers can ether self-label ther products, or have them certfed by a thrd party. The paper develops condtons that determne the optmal mposton of thrd-party labellng on producer types, and also compares the relatve effcences of self and thrd-party labellng schemes. When corrupt producers can cheat affxng spurous labels, we fnd that mandatory self-labellng schemes, accompaned by random montorng of the green frms, generally domnates mandatory thrd-party labellng, unless the market share effect greatly exceeds the ncentve-to-cheat effect causng regulatory costs to be very hgh under self-labellng. JEL Classfcaton: Q58, L5, D8 Keywords: Credence goods; Eco-labellng; Self-labellng; Thrd-party labellng; Cheatng; Montorng Department of Economcs, McGll Unversty, Montreal, H3T7, Canada, Emal: soham.baks@mcgll.ca correspondng author and paper presenter Department of Economcs, Unversty of Memphs, Memphs, TN 385, US, Emal: psbose@memphs.edu

2 . Introducton In recent years, there has been a growng publc focus, and consumer and polcy level concerns regardng goods whose producton processes may have envronmental consequences, or may nvolve practces that seem to volate notons of far trade or human rghts ssues. One manfestaton of consumer conscousness about the envronment s the ncreasng wllngness to pay a premum for greener products that are less harmful to the envronment (Tetenberg, 998; Forsyth et al., 999; macher, et al., 004; jorner, et al., 004). For example, usng data for Denmark, jorner et al. (004) found that Dansh consumers were wllng to pay a 3-8% prce premum on dfferent brands of tolet paper carryng the Nordc Swan eco-label. Smlar socal concerns may also be reflected by publc polces (spurred on by publc pressure, lobbyng, etc.) that restrct domestc producton or mports of tems from frms or countres that volate certan standards of envronment or far trade. For example, there may be a ban aganst mport of goods that utlze chld labour or other unfar employment practces or volate emssons standards. Ths wllngness of consumers to pay more for envronment-frendly goods amounts to ther voluntarly contrbutng to a publc good, and has been called mpure altrusm by ndreon (990). However, oftentmes consumers cannot ascertan the envronmental qualty of a product even after observng or consumng t. Ths mostly happens when the envronmental qualty of a product s related to ts producton process and s not an observable attrbute of the product. Such products are called credence goods (as dfferent from search goods and experence goods ), an example beng dolphn-safe tuna. Genetcally modfed (GM) food s another example of credence good. Due to the unsettled state of the scence of GM organsms, many consumers have concerns about the long-term ecologcal and health mpacts of GM crops. They are therefore wllng to pay less for the GM varety of a crop compared to ts non-gm varety. However, whether a y defnton, consumers observe the qualty of search goods before purchase, and experence the qualty of experence goods after consumpton. Sceptcsm about GM food s more wdespread n the EU as compared to North merca (Economst, 9 May 004).

3 product s genetcally modfed or not s an unobservable attrbute of the product to consumers. esdes those related to envronment and health, there may be other hdden attrbutes of a product that consumers can care about. For example, some consumers may be wllng to pay a premum for goods that are produced usng farer labour standards. Whle the present paper focuses on ecologcal aspects, t wll be evdent that our analyss can be appled to the nformaton revelaton ssues nvolvng all credence goods n general. When envronmental (or ecologcal) frendlness of a product s prvate nformaton to the producers, even non-green producers wll have an ncentve to pretend to be green n order to proft from the consumers hgher wllngness to pay. Therefore, n the absence of thrd party nterventon, consumers wll fnd t dffcult to beleve frms clams to the greenness of ther products, and frms wll n turn fnd t dffcult to sell greener products. Two ways n whch thrd party nterventon can break ths deadlock are: () eco-labellng by the frms themselves (.e. self-labellng), n conjuncton wth random montorng by an ndependent (government) agency; and () eco-labellng by a thrd party (a labellng agency). Such dsclosure strateges to ncrease nformaton on the envronmental frendlness of products have often been called the thrd wave n envronmental polcy (legal remedes lke emsson standards beng the frst wave, and market-based nstruments lke polluton taxes and emsson tradng, beng the second wave ). 3 Ever snce Germany set up ts lue ngel programme n 977, many developed and developng countres have establshed eco-labellng schemes. 4 s well, the Internatonal Standards Organsaton (ISO) has set up ts 4000 seres, whch certfes good envronmental practces by producers. The growng popularty of eco-labels, and some evdence of ther success, 5 has recently led economsts to formally analyse them. The default analytcal approach has been to treat eco-labels as another means of vertcal product dfferentaton avalable to frms. Qualty competton (usng eco-labels) among frms s modelled as another stage precedng prce or output competton n a mult-stage 3 See Tetenberg (998). 4 For an evaluaton of some of these programmes see OECD (997), and US EP (998). 5 For example n the US, tuna wthout dolphn-safe certfcaton has dsappeared from the market.

4 game. 6 macher, et al. (004) however model eco-labellng as an nvestment n a threestage game wth qualty and prce competton. Investment reduces the fxed cost of provdng qualty, whch s an observable product attrbute n ther model. Mason (000) looks at the welfare mplcatons of eco-labellng as an mperfect but costly sgnal of qualty. Sedjo and Swallow (00) fnd that consumers hgher wllngness to pay s not suffcent for a prce premum to exst for certfed goods. In another study, they show that, n a general equlbrum settng, eco-labellng of wood may lead to converson of forest land to other ecologcally less desrable uses (Swallow and Sedjo, 000). Other studes examne varous ssues lke voluntary overcomplance, where some frms voluntarly exceed legal envronmental standards (rora and Gangopadhyay, 995; Krchhoff, 000), and eco-labels as trade barrers (Greaker, 00; Tan, 003). Our paper focuses on a dfferent ssue. In a bnary case, where there are only two possble types of producers of a good, green and brown, labellng by any one type s suffcent to solve the nformaton asymmetry problem. The queston we address s, n such bnary cases, whch type should label ther product. Whle t s true that f labellng was truthful and purely voluntary only green frms would seek eco-labels, the government could legally mpose mandatory labellng on the brown frms f ths turned out to be welfare enhancng. 7 We fnd that the optmal labellng polcy depends on the cost structure of the frms, as well as the cost of labellng and government montorng (whch can also be nterpreted n terms of the market share of ether type). Two methods of labellng are consdered n ths paper self-labellng and thrd party labellng. These respectvely correspond to the ISO 40 (or Type II ) and ISO 404 (or Type I ) types of envronmental-product clams. 8 In self-labellng, frms make 6 Shaked and Sutton (98) showed that such qualty competton could be used to relax prce competton. 7 Examples of such mandatory negatve labellng nclude the state of Calforna s Proposton 65 (whch requres manufacturers to warn the publc about the hazards or adverse health mpacts assocated wth ther product), and the statutory warnng that appears on cgarettes. 8 thrd type (ISO 405) of envronmental clam requres the manufacturer to present quantfed product nformaton that consumers can use n makng purchase decsons. The nformaton s presented n a form that facltates comparson among smlar products. n example s the US FD s nutrton label. However, sometme such detaled techncal nformaton may be dffcult for consumers to nterpret. ecause the logos they carry (lke the Nordc Swan), or clams they make (e.g. x% recycled or bodegradable ), summarse the relevant nformaton, Type I and Type II labels are easer for consumers to follow. 3

5 clams about some hdden attrbute of ther product that consumers care about (e.g. made from x% recycled materal, organc, etc.). lthough such cheap talk s generally costless, there s an adverse selecton problem assocated wth t. In fact, to prevent msleadng advertsng by frms, organsatons lke the US Federal Trade Commsson, and the EC have ssued gudelnes for makng envronmental clams. In thrd party labellng, on the other hand, frms obtan permsson, n return for a payment, to use the logo or seal of approval ssued by a labellng agency (e.g. EU s Eco-Label, or Inda s Ecomark). The labellng agency s typcally a governmental or quasgovernmental organsaton. 9 Such costly sgnals are, n general, more credble to consumers. oth self-labellng and thrd party labellng are, however, susceptble to corrupton. Ths paper, therefore, also nvestgates optmal labellng rules when frms can cheat wth respect to ther labels, and the government has to montor frms labels n order to deter them from cheatng. Under self-labellng, a frm can cheat by smply makng false clams. On the other hand, under thrd party labellng, frms wll be able to cheat by ether evadng labellng rules, or by usng fake labels. 0 The rest of the paper s organsed as follows. Secton outlnes the model and solves for the full nformaton equlbrum (baselne case) when consumers can observe the product type and no labellng s requred. Secton 3 then looks at the asymmetrc nformaton case, when product type s unobservable, and labellng s always done truthfully. We show that the optmal labellng rule n ths case depends on the market share of ether good n the baselne case. Secton 4 also consders the asymmetrc nformaton case, but allows for the possblty of cheatng by frms wth respect to ther labels. In such stuaton, the cost of government montorng has to be factored n whle desgnng optmal labellng rules. Secton 5 concludes. 9 See US EP (998), p. 0 These ssues are further explored n secton 4. In ths paper we assume that t s only the frms, and not the labellng agency, whch can be dshonest. If the labellng agency were also corrupt, t could take a brbe from the brown frms n order to certfy ther products as green. However, we do not explore ths case here. 4

6 . The aselne Case: Complete Informaton Consder a good that s vertcally dfferentated nto two types: (brown) and (green). For nstance, the good could be a crop whch has a genetcally modfed varety (type ) and an organc varety (type ). Each type of the good s produced by a large number of dentcal frms under perfect competton wth free entry and ext. The total cost of producng q unts of type good ( =, ) conssts of the fxed cost K, and the varable cost c q. Wth p denotng the prce of type good, the proft of a representatve type frm producng q unts of type good s π = p q K c q. () Each frm maxmses proft wth respect to quantty by takng prce as gven. Due to free entry/ext, the equlbrum proft of each frm s zero. The frst order condton (FOC) for proft maxmsaton, together the zero-proft condton, yelds the equlbrum prce and quantty as p c K =, q = K / c. () Note that q s also the output that mnmzes the average cost c q + K / q. Thus, n equlbrum, each frm produces at ts mnmum effcent scale (the lowest pont of ts average cost curve). Wth complete nformaton, consumers can observe the good s type. It s assumed that each consumer nelastcally demands one unt of the good, and s wllng to pay ( M ) dollars for the type good, and M dollars for the type good. s a parameter that represents a consumer s measure of dstaste for the type good and s assumed to be unformly dstrbuted wth support [0,]. consumer s ndfferent between buyng good The complete nformaton equlbrum also results f the brown and/or green frms truthfully self-labelled ther good, and self-labellng s costless. 5

7 of ether type when M value of gven by p = M p. Thus the ndfferent consumer has a threshold = p p = ck ck. (3) We assume that the parameters of our model are such that both types of the good are produced n equlbrum,.e. ssumpton : Costs are such that < c K c K. 0 < Snce each type frm produces q unts of the good, the equlbrum number of type frms, n, s n / K c, (4a) = K / c = cc K / = ) / K / c = cc K / K + c / n ( K c. (4b) The market equlbrum under full nformaton as derved above can be shown to be socally optmal or frst best. The socal welfare s represented by W = 0 ( M ) d + Md ( K + c q ) / q ( K + c q )( ) / q = M ( q. (5) K + cq / ) / q ( K + cq )( ) The frst two terms on the R.H.S. of (5) represents the consumer surplus from the two types of the good, whle the thrd and fourth terms represent the total ndustry costs of producng each type (aggregated across frms of the same type). Note that n = / q, whle n = ( ) / q. Hence, W represents the dfference between consumer surplus 6

8 and producton costs n the economy. The government maxmses W wth respect to and. The FOCs are q K + c q ) / q + ( K + c q ) / q 0, (6a) ( = c ( K / q ) = 0. (6b) + From (6b), we have K = c q, when (6a) becomes or, c q + c q 0 (6a ) = ( M ) cq = M cq (6a ) The expressons on each sde of the above equaton represent the dfference between the surplus of the ndfferent consumer and the margnal cost of producton of the respectve type of the good. In other words, the frst-order condtons for welfare maxmzaton represent the fact that the socal planner decdes the optmal allocaton by equatng the net margnal beneft across the two types. Solvng (6a) and (6b) we get the socally optmal levels of outputs and market share as q = K / c, (7) W W = c c K. (8) K Comparng equatons (), (3), (7) and (8) we see that under full nformaton the market outcome s socally optmal. Ths s the famlar result that, n the absence of mperfect competton or ncomplete nformaton (or externaltes), markets are effcent. Substtutng () and (3) nto (5), gves the socal welfare under full nformaton as W = M + ( ) ck. (9) 7

9 3. Incomplete Informaton wth Truthful Labellng Now suppose that consumers cannot observe the good s type. No frm would have ncentve to produce the green good f t sold at a prce lower than that of the brown. If the green good sold at a hgher prce than the brown, all brown frms would want to pretend to be green. Thus, there cannot be an equlbrum where dfferences n prce sgnal the dfferent types. Consequently, no frm would fnd t proftable to produce the green good at a hgher cost. In such a stuaton, eco-labellng would serve as a mechansm for the dsclosure of nformaton that enables consumers to exercse ther preferences for the hdden attrbute. In ths secton we assume that all labellng s done by a thrd party, and that ths process results n accurate revelaton of the type of the good produced by any frm. If costless self-labellng s done truthfully, the outcome wll be dentcal to that analysed n the prevous secton. Therefore, we focus on costly thrd party labellng, and gnore, for the tme beng, the ncdence of delusons (such as fraud labels) practsed by frms: all labels are genune and ssued by the thrd party as the certfyng agency. Suppose that a frm of ether type has to pay the labellng agency l for each unt of output that carres the label. We assume that l s also the constant socal cost of labellng each unt of the good, and that the certfyng agency s a non-proft organzaton that acts to maxmse socal welfare by chargng l for each label. Ths labellng cost, for nstance, could be the cost ncurred by the labellng agency for analysng/testng some fracton of a frm s output. 3 Snce there are only two types, labels can be used by ether the brown or the green frms. Each case s analysed below separately to determne the socally optmal alternatve. If the certfyng agency has a fxed cost, and the constant margnal cost of l, the compettve equlbrum s also socally effcent f frms are charged l per label. Ths can be easly verfed by proceedng n a manner smlar to the analyss of secton. 3 Germany s Green Dot programme, for example, charges a labellng fee whch depends on the type and weght of packagng materals. 8

10 Case : Labellng by rown Frms Suppose thrd party labellng s mandatory for the brown frms. The proft of each brown frm then s pq K cq lq. The FOC for proft maxmsaton and the zero-proft condton together gve the new equlbrum prce and quantty for brown frms as p = ck + l = p + l, q = c = q. (0) K / Snce the green frms do not label, ther equlbrum prce-quantty combnaton remans unchanged. The market share of the brown good therefore decreases to = p p = l. () To rule out corner solutons, where only one type of the good s produced, we make the followng assumpton: ssumpton : The labellng cost, l, s such that l < c K ck < l holds. 4 Remark: For all l 0, ), f s satsfed, then s satsfed as well. ( Snce each brown frm contnues to produce the prevously optmal level of output ( q = q ), l / q brown frms have to ext the market when eco-labellng s mandatory for them. Ther place s taken up by l / q new green frms enterng the market. Socal welfare n case s 5 W = ( M ) d + Md ( K 0 + c ( q ) + lq ) q ( K + c ( q ) ) q 4 < l s necessary to ensure <. 5 Ignorng the labellng agency s fxed cost, f any. 9

11 = M + ( c K. () ) Thus ncomplete nformaton mposes a welfare loss on socety whch, when brown frms label, equals W = ( W W ) W l l) > 0. Snce = l > 0, ths welfare loss ( ncreases as the market share of the brown good ncreases. Case : Labellng by Green Frms Suppose that labellng s done by the green frms nstead. Proceedng as n case, t can be shown that equlbrum prce and quantty, when green frms label, are p = ck + l = p + l, q = c = q. (3) K / Increase n prce of the green good, rases the market share of the brown good to p = p = + l. (4) l / q green frms ext the market and are replaced by l / q brown frms. From equatons (0), (), (3) and (4), we have the followng result: Proposton : Under ncomplete nformaton, labellng by type frms reduces both the number of type frms as well as the market share of the type good, but leaves the output of each frm unchanged from ts optmal complete nformaton level. The above s because a lnear labellng cost shfts each labellng frm s average cost curve vertcally upwards wthout changng ts mnmum effcent scale. Socal welfare when green frms label s 0

12 W = ( M ) d + Md ( K 0 + c ( q ) ) q ( K + c ( q ) + lq ) q = M ( ) c K l. (5) + gan, ( ( W W ) W W = l l ) > 0 and = l < 0. Thus, the welfare loss when green frms label decreases when the market share of the brown (respectvely, green) good ncreases (respectvely, decreases). Moreover, snce W W = l( ) 0 f and only f, we have Proposton : Provded labellng s done truthfully, thrd party labellng under ncomplete nformaton should be mposed on producers of the type that has the smaller market share under complete nformaton. If complete nformaton yelds equal market share for each type, then from a welfare pont of vew, t does not matter whch type bears the labellng cost under ncomplete nformaton. Note that mples that c K + ck. Thus, thrd party labellng should be mposed on the green frms f and only f ther costs are suffcently larger than those of the brown frms. Proposton can be explaned by comparng the consumer surplus under complete nformaton and ncomplete nformaton (frms earn zero proft n equlbrum). When thrd party labellng s mposed on the brown good, ts prce rses by the amount of the labellng cost to p p + l, and ts market share falls to =. Compared to the = l complete nformaton stuaton, ncomplete nformaton wth labellng by brown frms nvolves the followng changes n consumer surplus: () consumers who bought the brown good under complete nformaton and contnue to do so under ncomplete nformaton suffer a declne n ther consumer surplus of amount l = l( l) ; () consumers who swtch from buyng the brown good under complete nformaton to buyng the green good under ncomplete nformaton see ther surplus decrease by an

13 amount ( p p )( ) d = l, whch reflects both the hgher prce of, as well as wllngness to pay for, the green good; () consumer surplus of those who buy the green good n both stuatons reman unchanged. On the other hand, labellng by green frms ncreases the green good s prce to p = p + l, and reduces ts market share to = l. Compared to the complete nformaton stuaton, ncomplete nformaton wth labellng by green frms changes consumer surplus n the followng ways: () consumers who buy the green good n both stuatons have ther surplus reduced by an amount l( ) = l( l) ; () consumers who swtch from consumng green good under complete nformaton to brown good under labellng, suffer a surplus reducton of d ( p p )( ) () consumer surplus of those who buy the brown good under both stuatons does not change. = l ; From the above, we see that a welfare comparson between brown frms labellng vs. green frms labellng nvolves only a comparson between l ( l) and l ( l),.e. the reducton n consumer surplus (from ts complete nformaton level) of those who consume the labelled good both before and after labellng. Snce labellng by ether type of frms ncreases the prce of ther good by the same amount (equal to the cost of labellng), the reducton n consumer surplus wll be less f labellng s mposed on the good wth the smaller market share. In other words, when the brown good has a larger market share ( > ), labellng by green frms reduces the consumer surplus less than labellng by brown frms. 4. Incomplete Informaton wth Cheatng and Montorng In the prevous secton we assumed that all labellng s done truthfully. However, n realty, labellng may be subject to corrupton. Specfcally, brown frms have an ncentve to pretend to be green n order to beneft from the hgher prce of the green

14 good. In ths secton we allow for the possblty that frms can cheat wth respect to ther labels,.e., make false clams or affx spurous labels to ther product that are not the authentc ones provded by the certfyng agency. 6 When brown frms can cheat and pretend to be green, the government has to montor the green frms n order to ensure that labellng s done truthfully (or, by the proper agent). Suppose, the government randomly nspects m green frms for the accuracy of ther labels, and mposes a fne of an amount F on any brown frm caught pretendng to be green. 7 F s assumed to be an exogenous parameter, perhaps set by the judcary, but outsde government control. To prevent cheatng, the government has to choose a suffcently hgh m such that the expected fne offsets the extra proft from cheatng. We assume that f ts expected net proft from cheatng s zero, then a frm does not cheat. If s the total number of green frms n the ndustry, then the detecton probablty of a brown frm that cheats s m / n, n and ts expected fne s mf / n. Clearly, f the fne can be made arbtrarly large, then the number of frms the government needs to nspect wll go to zero. However, socal conventons (e.g. penalty should be commensurate wth crme) prevent settng a large F. 4. Three Labellng Optons When brown frms can cheat, and the government has to randomly montor the green frms, t has three optons wth respect to ts labellng polcy: () the government may mpose thrd party labellng on the brown frms, or () t may mpose thrd party labellng on the green frms, or () the government may ask the frms to self-label ther own products. Each of these optons s consdered below separately. When the government makes thrd party labellng mandatory for the brown frms (as n secton 3, case ), the prce of the brown good rses by the amount of the labellng cost to p, and the brown good s market share falls to. Wth mandatory labellng, a brown frm can pretend to be green by smply not obtanng a label from the labellng agency. The proft that a brown frm can get by not obtanng a label s ~ π = p q K c q 6 Recall that we gnorng the case where the labellng agency tself can be dshonest. 7 The dfferent ways a brown frm mght pretend to be green wll be made clear shortly. 3

15 (a tlde over a varable denotes ts value n the cheatng case). The corrupt brown frm maxmses ths proft by producng quantty ~ p q = / c. Snce p = p = ck, the maxmsed cheatng proft s ~ π = ( ck c K) / c > 0. The total number of green frms, when brown frms have to label, s n = ( ) / q. On the other hand, when green frms are requred to obtan a label from the labellng agency (as n secton 3, case ), the prce of the green good rses to p = p + l = ck + l, and ts market share falls to ( ). Wth mandatory labellng mposed on green frms, a brown frm can pretend to be green by carryng a fake label. We assume that ths fake label perhaps an mtaton of the label or certfcate ssued by the labellng agency to green frms s costless to the frms. 8 The proft that a brown frm can get by usng a fake label s ~ π = q K ( ck + ) l = π + l / the labellng cost, falls to n ( ) / q = < n. p cq, or maxmsed ~ π ~ c. The total number of green frms, when green frms bear thrd opton for the government s to requre the brown and/or green frms to self-label ther own product. Unlke thrd party labellng, self-labellng s costless. Hence, under self-labellng, the prce of the type good remans unchanged at p = c K, and the market share of the brown good stays at. The cheatng proft of a brown frm, whch self-labels tself as green, then s n S ck ck ) / c = ) / ( q, wth n < n < n. ~ π = p q K c, or maxmsed S q ~ π = ( = ~ π. 9 The total number of green frms under self-labellng s s mentoned earler, the government chooses the number of frms t randomly nspects, m, such that the amount of fne any brown frm consderng cheatng expects to pay 8 We are referrng only to the drect cost of obtanng fake labels here. Indrect cost of usng fake labels wll nclude the expected fne. green frm wll never use a fake label to save on ts labellng cost, as the expected fne wll exceed ts extra proft. We are assumng that brown frms and green frms are fned the same amount, F, for usng fake labels. 9 Superscrpt S stands for self-labellng. 4

16 ( = mf / n ) equals the extra proft ths frm can get from such cheatng ( ~π, or ~π, or S ~π, dependng on the labellng polcy adopted by the government). Thus, when t mposes thrd party labellng on brown frms, the number of frms that the government has to nspect n order to ensure an expected fne of ~π s m ( + l) c ~ = π (6) F K On the other hand, the number of frms that the government has to nspect, when thrd party labellng s mposed on green frms, s m ( l) c ( l l = ~ π + ck + ) F K c (7) Fnally, under self-labellng, the government has to nspect brown frms from cheatng, where S m frms n order to deter S m ( ) c ~ = π (8) F K 4. Thrd Party Labellng by Green vs. rown Frms Imposng costly thrd party labellng on the green rather than the brown frms leads to a hgher prce of the green good. Ths has two opposng effects on the number of frms the government has to nspect. Frst, t ncreases the ncentve of brown frms to cheat, as brown frms can get a hgher proft from cheatng when green frms have to label ( ncentve-to-cheat effect ). Ths mples that the government wll have to ncrease the detecton probablty by nspectng more frms, so as to deter brown frms from cheatng. Secondly, however, an ncrease n prce of the green good decreases ts market share, and results n fewer numbers of green frms, as some green frms ext the market ( market share effect ). The lower total number of green frms mples that the government has to 5

17 nspect fewer frms n order to attan the probablty of detecton that deters brown frms from cheatng. When the ncentve-to-cheat effect domnates the market share effect, m exceeds m,.e. the government has to nspect more frms when t mposes thrd party labellng requrement on green frms rather than on brown frms. If nspectng each frm costs the government h dollars, then the dfference n welfare that arses when thrd party labellng s done by green frms rather than by brown frms s ~ W ~ W = { M + ( ) } { ck l hm M + ( ) ck hm } h( m m ) = l l. (9) Thus we get the followng result: Proposton 3: When the government has to montor frms labels n order to ensure they are not cheatng, then costly thrd party labellng should be mposed on green frms f and only f > + h( m m )/ l greens label rather than browns (.e. m > m. If the government has to montor more frms when ), then brown frms mght have to label even f the brown good had more than half the market share under complete nformaton. Smlarly, when m > m, green frms mght have to label even f the green good had the domnant market share under complete nformaton. Thus, when brown frms can cheat and the government has to montor frms, costly thrd party labellng need not always be mposed on the good that has the smaller market share under complete nformaton. Ths s because of an addtonal welfare consderaton the cost of government nspecton nvolved n such case. 4.3 Self-labellng vs. Thrd Party Labellng by rown Frms Snce self-labellng s costless to frms, t does not ncrease the prce of ether good. Costly thrd party labellng by brown frms, on the other hand, ncreases the prce of the brown good but leaves the prce of the green good unchanged. The ncentve of a brown 6

18 frm to cheat s, therefore, the same rrespectve of whether the government mposes self- S labellng or thrd party labellng on brown frms (cheatng proft equals ~ π = ~ π n ether case). However, thrd party labellng by brown frms ncreases the market share of the green good. Ths mples that the government has to nspect more frms under thrd party labellng than under self-labellng. Moreover, thrd party labellng mposes the addtonal labellng cost on socety, whch self-labellng does not mpose. Thus, we have Proposton 4: When frms can cheat and the government has to nspect frms labels, self-labellng s better than thrd party labellng by brown frms, as t mposes less (labellng and nspecton) costs on socety. Specfcally, the dfference n welfare between self-labellng vs. thrd party labellng by brown frms s ~ W S ~ W = { M + S ( ) } { c K hm M + ( ) c K hm } hl ( ) l + c K ( c K c K) > 0 = l. (0) c K F Note that the frst term on the R.H.S. of (0) s strctly postve, gven ssumpton. In fact, Proposton 4 s lkely one justfcaton why almost all exstng thrd party labels are postve (green), and not negatve (brown), n character. Negatve labels, n practce, tend to be mandatory self-labels that brown manufacturers are requred to attach to ther product (for example, pestcde labellng under FIFR n the US) Self-labellng vs. Thrd Party Labellng by Green Frms Compared to self-labellng by brown and/or green frms, thrd party labellng by green frms, whch rases the prce of the green good, has three effects on welfare. For one, brown frms have a hgher ncentve to cheat, whch mples that the government has to 0 Manufacturers may also voluntarly attach hazard/warnng labels on ther products for lablty purposes (US EP, 998). 7

19 nspect more frms. For another, as the market share of the green good falls, the government has to nspect fewer frms. Thrd, thrd party labellng reduces welfare by mposng the labellng cost on socety. The frst and the thrd effect tend to reduce the ~ ~ S welfare dfference ( W W ), whereas the second effect tends to ncrease t. The relatve strength of these three effects determnes whether the government should opt for self-labellng or thrd party labellng by green frms. The welfare dfference between these two labellng optons can be expressed as ~ W S ~ W = l( l) S ( m m ) + h () The frst term on the R.H.S. of () s postve by ssumpton. Thus we have the followng result: Proposton 5: If the government has to nspect more frms when t mposes thrd party labellng on the green frms than when t mposes self-labellng (.e. m > m S ), then the government should choose the self-labellng opton. Self-labellng s also optmal f m S slghtly exceeds m. Only f m s suffcently larger than m, so as to offset the other advantages dscussed above, should the government opt for thrd party labellng by green frms rather than self-labellng. S S The relatve magntude of m and m, of course, depends on the relatve strengths of the ncentve-to-cheat effect and the market share effect. 5. Concluson Ths paper has analysed optmal labellng polcy for credence goods when frms can cheat wth respect to the label they attach to ther product. Labellng as an nformaton dsclosure mechansm becomes mportant when consumers care about an attrbute of a product whch s unobservable to them. For example, although some consumers may be averse to buyng carpets whch are manufactured usng chld-labour, they wll not be able S Specfcally, f m > m + l l) / h. ( 8

20 to make an nformed choce unless they can dstngush between carpets whch do and do not use chld-labour. We show that, f frms always honestly mplement the labellng polcy, then the government should mpose costly thrd party labellng requrement on the good that has the smaller market share under complete nformaton. Of course, when frms always label honestly, the self-labellng polcy would trvally lead to the frst best outcome, and would be most preferable. More realstcally, when frms can be corrupt n ther mplementaton of the publc labellng polcy, the government wll have to undertake random and costly montorng of frms n order to deter brown frms from cheatng and pretendng to be green. In such stuatons, we show that costly thrd party labellng mght have to be mposed on a good that has the domnant market share under complete nformaton. s well, we fnd that mposng mandatory self-labellng requrement on brown frms s better than mposng mandatory thrd party labellng requrement on them. Self-labellng by brown and/or green frms s also preferable to costly thrd party labellng by green frms, unless the labellng cost s so hgh that the market share effect greatly exceeds the ncentve-tocheat effect, and the government has to montor many more frms under self-labellng. Whle we have consdered constant unt varable cost (and lnear prce) of labellng by the thrd-party, t may also be the case that the latter wll obtan a share of the revenue from the producers whose products they certfy. In such cases there wll be a schsm between the labellng costs (that fgure n socal costs) and the prcng scheme (whch s a transfer payment) charged by the thrd-party, and the outcomes of our analyss may alter. In our future research, we ntend to focus on such ssues wthn the context of an ad-valorem prce of labellng. The Nordc Swan, for example, charges an annual fee, whch s 0.4 percent of a producer s annual sales. 9

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