Working Paper: NBER ID: w26221
Authors: Hugo Hopenhayn; Maryam Saeedi
Abstract: This paper considers the design of an optimal rating system, in a market with adverse selection. We address two critical questions about rating design: First, given a number of categories, what are the criteria for setting the boundaries between them? Second, what are the gains from increasing the number of categories? A rating system helps reallocate sales from lower- to higher-quality producers, thus mitigating the problem of adverse selection. We focus on two main sources of market heterogeneity that determine the extent and effect of this reallocation: the distribution of firm qualities and the responsiveness of sellers' supply to prices. We provide a simple characterization for the optimal rating system as the solution to a standard k-means clustering problem, and discuss its connection to supply elasticity and the skewness of firm qualities. Our results show that a simple two-tier rating can achieve a large share of full information surplus. Additionally, we characterize the conflicting interests of consumers and producers in the design of a rating system.
Keywords: No keywords provided
JEL Codes: D21; D47; D60; D82; L11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| better information (D83) | total surplus (D46) |
| better information (D83) | consumer surplus (D46) |
| supply elasticity (Q31) | consumer surplus (D46) |
| distribution of firm qualities (L15) | thresholds set for ratings (C24) |
| supply elasticity (Q31) | thresholds set for ratings (C24) |
| thresholds set for ratings (C24) | market outcomes (P42) |
| rating system structure (R50) | efficiency of market outcomes (D61) |
| thresholds maximizing total surplus (D61) | thresholds maximizing consumer surplus (D41) |
| thresholds maximizing total surplus (D61) | thresholds maximizing producer surplus (D41) |