Credence goods, costly diagnosis, and subjective evaluation

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 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 we show that the first-best is also always implementable if diagnosis and treatment can be separated by contracting with two different agents.