An Empirical Examination of Quality Certification in a “Lemons Market”

I. INTRODUCTION Researchers have long understood that a variety of mechanisms may be used to overcome problems of adverse selection. Stigler (1961, 224) notes that "[s]ome forms of economic organization may be explicable chiefly as devices for eliminating uncertainties in quality," and Akerlof (1970) cites independent groups, such as the Consumers Union and United Laboratories, that test and certify the quality of goods. There is, however, little empirical evidence that illustrates the effectiveness of such mechanisms. In this article we examine the effect certification has on a market characterized by adverse selection. Using data from the market for young thoroughbreds, we compare the performance of sales where auction houses provide certification services with sales where certification is absent. The thoroughbred racehorse market consists of two distinct types of public auctions: certified and noncertified sales. In a certified sale, auction houses physically inspect the horses nominated to their sales, selling only the horses they conclude are from the upper end of the quality distribution. In noncertified sales, auction houses sell all horses nominated to a sale. Our empirical strategy is to perform tests that indicate whether adverse selection affects market outcomes in either certified or noncertified sales. A finding that adverse selection is present in noncertified sales but absent in certified sales is consistent with the hypothesis that certification alleviates problems of adverse selection. We adopt three approaches to test for the presence of adverse selection. (1) The first approach is in the spirit of Chiappori and Salanie (2000), who examine the relationship between unobservable factors from participation and performance equations. We model adverse selection as a case of sample-selection bias and examine the correlation between errors in participation and price equations. (2) To accomplish this we use a unique data set that allows us to estimate how breeder decisions to sell or retain horses affect market prices. The data set consists of a 10% random sample of all thoroughbreds born in 1993 and includes both horses retained by their breeders, who own a horse at the time of its birth, and horses that breeders chose to sell. Our second test follows Genesove (1993) and Chezum and Wimmer (1997) by examining the relationship between seller characteristics and price. Theoretically, when observable seller characteristics are correlated with seller incentives to select goods adversely, prices should reflect these differences. Chezum and Wimmer observe that some breeders sell all of their horses, whereas others retain a portion to race. They find that market prices are inversely related to the extent of a breeder's involvement in racing, concluding that adverse selection affects market outcomes. We extend this work in two respects. First, we isolate the effect seller characteristics have on price through the decision to sell or retain a horse. Second, we compare the effect seller characteristics have on observed prices in certified and noncertified sales. Our last test follows Bond (1982) who attempts to identify adverse selection in the market for used trucks by comparing the repair records of trucks that were sold with the records of trucks retained by their original owners. Because the horses in our sample had not begun their racing careers at the time they were sold, we use data on racetrack earnings as an ex-post measure of quality and compare the quality of horses sold in noncertified sales with certified horses and horses retained by their breeders. The results from each approach are consistent with certification alleviating problems of adverse selection. We find that holding observable attributes constant, horses that would receive unusually high market prices in noncertified sales are even more valuable in other options and are less likely to be sold in a noncertified sale. …