Bart van Vooren, University of Copenhagen, Copenhagen, Denmark
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Peter Rott Editor Certification – Trust, Accountability, Liability
Editor Peter Rott
University of Kassel
Kassel, Germany
ISSN 2214-2037
ISSN 2214-2045 (electronic)
Studies in European Economic Law and Regulation
ISBN 978-3-030-02498-7 ISBN 978-3-030-02499-4 (eBook)
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Peter Rott
Part I Foundations
Certification as Solution to the Asymmetric Information Problem?
Georg von Wangenheim
Challenges for Responsible Certification in Institutional Context: The Case of Competition Law Enforcement in Markets with Certification
Victoria I. Daskalova and Michiel A. Heldeweg
The Use of Conformity Assessment of Construction Products by the European Union and National Governments: Legitimacy, Effectiveness and the Functioning of the Union Market
Richard Neerhof
Part II Success and Shortcomings of Certification Systems
Privacy Through Certification?: The New Certification Scheme of the General Data Protection Regulation
Gerrit Hornung and Stefan Bauer
Can Certification Enhance the Feasibility of Insurance?
Miranda P. M. Meuwissen
Control in the Label: Self-Declared, Certified, Accredited?
Hanna Schebesta
Certification of the Sustainability of Biofuels in Global Supply Chains . . .
Carola Glinski
Part III Liability for Negligent Certification
Certification of Medical Devices: Lessons from the PIP Scandal . . . . . . . . 189
Peter Rott
Public Function Liability of Classification Societies . . . . .
Vibe Ulfbeck and Anders Møllmann
213
Liability of Rating Agencies Under German and European Law . . . . . . . . 231
Axel Halfmeier
Introduction
Peter Rott
1 The Theme of the Book
Certification means the confirmation of compliance with a pre-defined standard relating to a business, a product, a service or a management system. That standard can be a public law standard, a private standard or a hybrid.1
Certification has become a hot topic, in particular at the European level. It is a popular instrument of private governance of public goods, promising greater effectiveness than control by public authorities while at the same time taking the burden away from the State and its budget. Being a private instrument, it had long been attributed to the private sphere; which has changed drastically through recent decisions of the Court of Justice of the European Union (CJEU) that take into consideration the immense factual power of at least some private actors with regard to the facilitation of trade or to creating obstacles to trade. In the case of Fra.bo, 2 the German privately organised Deutsche Vereinigung des Gas- und Wasserfaches eV (DVGW) denied the certification of copper fittings for piping for water or gas, produced by the Italian producer Fra.bo. The Court held that Article 28 TFEU on the free movement of goods must be interpreted as meaning that it applies to standardisation and certification activities of a private-law body, where the national legislation considers the products certified by that body to be compliant with national law and that has the effect of restricting the marketing of products which are not certified
1 For detailed account, see chapter 3 by VI Daskalova and MA Heldeweg. See also Schepel (2005), p. 3 ff.
2 CJEU, 12/7/2012, Case C-171/11, Fra.bo SpA v Deutsche Vereinigung des Gas- und Wasserfaches eV (DVGW) — Technisch-Wissenschaftlicher Verein, ECLI:EU:C:2012:453.
P. Rott (*)
Institute of Economic Law, Faculty of Economics and Management, University of Kassel, Kassel, Germany
P. Rott (ed.), Certification – Trust, Accountability, Liability, Studies in European Economic Law and Regulation 16, https://doi.org/10.1007/978-3-030-02499-4_1
by that body. The decision in the case of James Elliott3 complemented this line of thinking. In this case, the CJEU found that it has jurisdiction to provide a preliminary ruling concerning the interpretation of a harmonised standard that was developed by a private body under the so-called ‘New Approach’ of EU product safety law, thus treated that private standard as part of EU law. The two decisions have triggered intense discussion relating to the constitutionalisation of standardisation and certification by private actors, in particular in the context of the ‘New Approach’.4
In a parallel development, the relevance of certification and similar phenomena, such as credit ratings, for the protection of the economic interests or the health and safety of third parties has come to the fore. The breast implants scandal around the French producer Poly Implants Prothèse (PIP) forms a prime example. PIP had filled the breast implants with industrial silicone rather than medical silicone. Within the system of EU medical devices law, TÜV Rheinland acted as notified body to monitor the activities of PIP. TÜV Rheinland had certified compliance of the product design of the PIP breast implants and of PIP’s quality management system with the underlying standard. Since TÜV Rheinland had not noticed the fraudulent change of production by PIP (and since PIP itself went bankrupt following the discovery of the fraud), victims initiated litigation against TÜV Rheinland in German and French courts. Out of the many cases, the case of Elisabeth Schmitt was referred to the CJEU.5 Rating agencies, in turn, attracted the attention of policy-makers and of investors likewise in the context of the financial crises, and in particular of the collapse of Lehman Brothers whose financial products had been rated “AAA” by Standard & Poor’s. Litigation has already been initiated in different countries including Australia and Germany.6
The above-mentioned areas of medical devices, or product safety generally, and of credit rating are only two examples for areas in which certification plays an important role. Other areas are the certification of food standards, of social and/or environmentally sound production or sourcing or of compliance with standards of consumer law or data protection law.
The cases of PIP and Lehman Brothers trigger several questions. Who benefits from certification? Standardisation benefits primarily the relevant industry whose transactions costs are reduced through standardisation and through certification of compliance with certain standards.7 At the same time, certification systems may serve further purposes, such as the protection of users or other third parties, and the certificates that are issued may be addressed to a diversity of actors. Thus, the main addressee of certificates can be the customer of the producer or trader who or whose
3 CJEU. 27/10/2016, Case C-613/14 James Elliott Construction Limited v Irish Asphalt Limited, ECLI:EU:C:2016:821.
4 See, for example, Schepel (2013), p. 530; van Leeuwen (2013), p. 406; Purnhagen (2017), p. 586; Volpato (2017), p. 597; Colombo and Eliantonio (2017), p. 332.
5 CJEU, 16/2/2017, Case C-219/15 Elisabeth Schmitt v TÜV Rheinland LGA Products GmbH, ECLI:EU:C:2017:128. See chapter 9 by P Rott and the references therein.
6 See chapter 11 by A Halfmeier and the references therein.
7 See, for example, DIN (2000) and Blind et al. (2011).
products, services, or management are certified, as in the case of credit rating or of the certification of social and/or environmentally sound production. Certificates may, however, be also addressed to public bodies where certification is part of a public law control system, for example of cars, aircrafts or medical devices. Or, they may serve the purpose to assist other third parties such as insurers that may base their risk calculation on certificates that confirm compliance with certain standards.
Another set of questions concern the regulatory design. Which design fits a certification system best? Which incentive system, including sanctions, should be in place to ensure compliance of certification bodies? This may depend on a variety of factors, including the way in which the certification body is involved (solicited by the actor that is to be certified or commissioned by an independent party) or the geographical scope of the certification system (national, EU-wide or global). Within that context, (private law) liability may play an important role not only in providing compensation to victims but also as a regulatory instrument to ensure compliance.
The book at hand unfolds the merits and perils of certification, employing the perspectives of different disciplines and using examples from different areas of life and law. There is an increasing amount of literature available on individual certification systems as well as on the relevance of standardisation and certification for (cross-border) trade, not least triggered by the above-mentioned recent case law of the CJEU. This book takes research from various areas up and presents certification as a cross-cutting issue. It invites lawyers and regulators from different branches, in which certification plays a role, to learn from the experience of other branches, rather than re-inventing the wheel time and again for each specific area. Indeed, it is one aim of the book to discover commonalities between certification systems but also to find differences that call for differential treatment.
2 The Structure of the Book
The book is structured in three parts. Part 1, consisting of three chapters by Georg von Wangenheim, Michiel Heldeweg and Victoria Daskalova, and Richard Neerhof, focuses on the fundamentals of certification: its economic background, the manifold shapes and forms certification can take, and its relevance for competition and free trade.
The chapters of Part 2 deal with the conditions for the success of certification in creating trust as well as incentives for compliance with private standards, and in monitoring compliance with standards, using examples from various sectors. Gerrit Hornung and Stefan Bauer introduce and discuss the new data protection seal as envisaged by the General Data Protection Regulation. Miranda Meuwissen presents empirical studies that show how certification gains relevance for insurance by facilitating risk classification and management. In a more skeptical approach, Hanna Schebesta looks at problematic (voluntary) certification practices in the food sector and presents the new certification marks of the EU Trademark Regulation of 2015
as a potential solution. Carola Glinski describes the certification of biofuels under EU renewable energies law and its shortcomings that are, among others, caused by long supply chains that often begin in the developing countries of the Global South.
Parts 3 takes the perspective of third party liability for negligent or fraudulent certification as a regulatory instrument that may be necessary to complement public law control of certification bodies but also discusses impediments to third party liability stemming from the rules on jurisdiction, private international law or contract and tort law doctrine that do not sufficiently accommodate harm caused to more or less remote third parties. This perspective is elaborated with regard to specific certification systems and their particularities. Peter Rott discusses the sector of medical devices and the PIP scandal, Vibe Ulfbeck and Anders Møllmann analyse, in a comparative manner, the liability of classification societies that certify the safety of vessels, and Axel Halfmeier explores the liability of rating agencies for losses of investors that trust in their ratings.
3 The Individual Chapters
3.1 Part 1: Foundations
In his chapter on ‘Certification as solution to the asymmetric information problem?’, Georg von Wangenheim introduces certification as a communication instrument that is meant to help the customer to make an informed choice. Economic theory sees certification as a solution to the informational problems of experience and credence goods. The problem is that certification in itself is an experience or credence good; which may entice opportunistic behaviour of certifiers. Von Wangenheim discusses possible solutions to that problem but also identifies open questions to the design of a good legal framework for the certification market, from an economic point of view.
Michiel Heldeweg and Victoria Daskalova look at certification from a legal governance perspective within particular institutional contexts. In their chapter on ‘Legal Design of a Meta-Regulatory Regime for Responsible Certification’, they distinguish the contexts of competitive/unregulated markets, public hierarchies and civil society and discuss the legal requirements that follow from these contexts as regards a responsible use of certification. The first part of this chapter discusses the main functionality and relevance of certification as a regulatory instrument— whether in a market setting or in the context of public hierarchy. In its second distinct part, the chapter focuses on competitive markets and on the risks for market access that may stem from certification systems, and how competition law doctrine can be used to set limits to such negative externalities. This is discussed in the context of an unregulated market as well as in the context of public hierarchy where certification acts as a substitute of granting public permission or is conditional to the
grant of such a permission, or where certification is part of public enforcement or a substitute thereof.
Richard Neerhof, in his chapter on ‘The Use of Conformity Assessment of Construction Products by the European Union and the Dutch Government: Issues of Legitimacy, Effectiveness and Functioning of the Union Market’, uses the example of the certification of construction products under two different certification regimes, stemming from EU law and from Dutch national law, to discuss the broader issues of legitimacy and effectiveness of certification within product safety law. The chapter first explains the basic concept of how certification (and standardisation) is integrated into the so-called ‘New Approach’ to product safety law and then discusses in great detail the risks that the system poses with regard to the inclusion of all relevant interests, to equal market access, and finally the quality of regulation and control, an issue that is taken up in other contributions in relation to specific markets.
3.2 Part 2: Success and Shortcomings of Certification Systems
Part 2 starts with Gerrit Hornung’s and Stefan Bauer’s chapter on ‘The new European Data Protection Seal – data protection through market’ that discusses the increasing prominence of certification in the sector of data protection. Under the new General Data Protection Regulation (GDPR), audit and certification mechanisms are means of co-regulation and aimed at creating market incentives. This optional enforcement layer is meant to enhance the standard of privacy protection. At the same time, the authors show that the new rules offer the opportunity to create transparency through a system of harmonised standards with regard to privacy seals and marks; instruments that have been used in the market before but with limited informative value, due to the lack of common standards.
That certification is indeed suitable to build trust is shown by Miranda Meuwissen in her chapter ‘Can certification enhance the feasibility of insurance?’. The feasibility of insurance heavily depends on the behaviour of the insured. Certification can be a tool to facilitate risk classification and monitoring. The author presents findings from empirical studies on liability insurance in the animal feed industry, epidemic disease insurance for farmers, and liability insurance in the horse business, that illustrate that certification schemes have the potential to enhance feasibility of insurance schemes, among others as a tool to cope with adverse selection.
In contrast, Hanna Schebesta rather deals with ‘bad’ certification practices, using the food sector as an example. In her contribution ‘Control in the label - selfdeclared, certified, accredited? - On-pack consumer communication about compliance control in voluntary food schemes from a legal perspective’, she identifies problematic certification practices in the domain and explores the potential of the current regulatory framework of unfair commercial practices law to effectively combat these practices. Moreover, she discusses a new legal development that might provide for more stringent solutions than food information law in the narrow sense:
EU certification marks that were introduced with the new EU Trademark Regulation of 2015 and that are meant to inform end-consumers of product qualities related to the largely opaque steps of the process leading to the product to which they are affixed.
The last chapter of Part 2, by Carola Glinski on ‘Certification of the sustainability of biofuels in global supply chains’, deals with an area where public law control of the production chain is not possible, due to public international law limitations, but where simple exclusion of foreign actors or products is not feasible either, due to the requirements of international trade law. The promotion of biofuels in the EU aims at the substitution of fossil fuels and the reduction of carbon emissions. In order to make sure that the production of biomass does not result in negative impacts on greenhouse gas stocks or on biodiversity, the promotion of biofuels is accompanied by sustainability requirements. As the majority of biomass for biofuels is produced in the ‘Global South’ with often low regulatory and enforcement capacities, compliance with the sustainability requirements is safeguarded through a highly complex certification set-up based on private certification systems and private certification bodies which thereby replace, to a certain extent, the regulatory and administrative role of the State. The author analyses that system of control and its potential weaknesses to ensure sustainable production of biofuels.
3.3 Part 3: Liability for Negligent Certification
Peter Rott picks up the topic of the effectiveness of private certification in product safety law and the role of tort law liability for the compensation of victims of negligent certification and as a regulatory instrument to incentivise certification bodies to live up to their duties. In his contribution ‘Certification of medical devices: Lessons from the PIP scandal’, he describes the development of certification and accreditation in medical devices law. Having started with a fairly general framework, proven failures in the system, and in particular the breast implant scandal around the French producer Poly Implant Prothèse (PIP) and the German certification organisation TÜV Rheinland, medical devices law has seen ever more intense regulation of the control chain, culminating in the new Medical Devices Regulation of 2017. The narrative of the legislative history and the reasons for the various legislative changes illustrate the risks that come with the privatisation of health and safety regulation and control and trigger the question as to whether private law liability of certification organisations towards victims of unsafe medical devices is a necessary ingredient to make the system work.
Liability for insufficient control by certification organisations is also at the heart of the contribution by Vibe Ulfbeck and Anders Møllmann on ‘Public function liability of classification societies’, dealing with the certification of vessels. Among others, flag states commonly delegate it to classification societies to perform surveys and inspections pursuant to various international conventions and to issue certificates under these conventions on behalf of the flag state (statutory certification).
If a ship that has been so certified is involved in an incident causing damage to a third party, the question arises whether that third party can hold the classification society liable in damages. The authors show how the public function of such certification adds an extra layer of complications if the activity of the classification society is attributed to the flag state itself, potentially triggering procedural and/or substantive immunity in different legal systems, and how the limited liability for statutory certification has recently even spilled over to commercial certification of classification societies.
Rating of financial products, finally, is another system that is meant to build trust between issuers of financial products and investors but that has gained a dubious reputation through the 2008 financial crisis, where rating agencies were identified as actors that contributed to the crisis. Axel Halfmeier describes in his chapter on ‘Liability of Rating Agencies under German and European Law’, how in various legal proceedings—some of which are still pending until today—the question of the liability of rating agencies vis-à-vis investors was raised. The author analyses such claims with regard to jurisdiction and applicable law, and discusses substantive German law as well as first case law on this question. In addition, the recent European legislation on rating agencies’ liability and its relation to Member States’ private laws is covered.
4 A Word of Thanks
‘Certification Bodies – Trust, Accountability, Liability’ was the title of a bilateral international workshop to support the initiation of international collaboration between the Universities of Kassel and Wageningen. It was organised by Peter Rott and Martina Deckert at the University of Kassel, with Kai Purnhagen from the University of Wageningen as co-operation partner. The workshop was funded by the Deutsche Forschungsgemeinschaft (DFG), for which the editor wishes to express his gratitude.
References
Blind, K., Jungmittag, A., & Mangelsdorf, A. (2011). Der gesamtwirtschaftliche Nutzen der Normung. DIN. Colombo, C., & Eliantonio, M. (2017). Harmonized technical standards as part of EU law: Juridification with a number of unresolved legitimacy concerns? Case C-613/14 James Elliot Construction Limited v. Irish Asphalt Limited, EU:C:2016:821. Maastricht Journal of European and Comparative Law, 24, 332. DIN. (2000). Gesamtwirtschaftlicher Nutzen der Normung - Unternehmerischer Nutzen. DIN. Purnhagen, K. (2017). Voluntary “New Approach” technical standards are subject to judicial scrutiny by the CJEU! – The remarkable CJEU judgment “Elliott” on private standards. European Journal of Risk Regulation, 8, 586.
Schepel, H. (2005). The constitution of private governance – Product standards in the regulation of integrating markets. Oxford, England: Hart.
Schepel, H. (2013). The new approach to the new approach: The juridification of harmonized standards in EU law. Maastricht Journal of European and Comparative Law, 20, 530.
van Leeuwen, B. (2013). From status to impact, and the role of national legislation: The application of article 34 TFEU to a private certification organisation in Fra.bo. European Journal of Risk Regulation, 4, 406.
Volpato, A. (2017). The harmonized standards before the ECJ: James Elliott Construction. Common Market Law Review, 57, 597.
Part I
Certification as Solution to the Asymmetric Information Problem?
Georg von Wangenheim
1 Introduction
Certification of products, services and even certification agencies aims at various objectives. If certification is a prerequisite for bringing a product or service to the market, it is not much different from quality regulation organized as a general prohibition of the product with individual permission as the exception. If it is a private agency that provides certification under these circumstances, certification is tantamount to out-sourcing of genuine government activity. This form of certification is not topic of this contribution. Certification may also aim at solving or alleviating a problem of asymmetric information. A certificate is then similar to a signal of a supplier on the quality of his products. Obviously, producers may also refrain from sending the signal, that is, they may supply their product without certificate. The economic literature has discussed certification in this voluntary sense in several perspectives. The objective of this chapter is to review this literature and thereby to lay the grounds for the ensuing legal analysis in this book.
I will first remind the reader of the distinction between search goods on the one hand and experience and credence goods on the other hand (Sect. 2). This will allow me to recapitulate the basic model of certification due to Viscusi1 in Sect. 3. I will proceed with a number of variations of this model. In Sect. 4, I will report how some of the literature allows for opportunism of certification agencies, either by withholding information or by exerting less than socially optimal effort on collecting information about the goods to be certified. Hardly surprising, this also includes collusion
1 Viscusi (1978), p. 277.
G. von Wangenheim (*)
Institute of Economic Law, Faculty of Economics and Management, University of Kassel, Kassel, Germany
P. Rott (ed.), Certification – Trust, Accountability, Liability, Studies in European Economic Law and Regulation 16, https://doi.org/10.1007/978-3-030-02499-4_2
G. von Wangenheim
between producers and certifiers. Section 5 studies certification of reaching minimum standards including decisions on how such standards become determined. I then (Sect. 6) collect a number of variations to the basic Viscusi model which suggest themselves as fields of further investigation but which so far have not or hardly been discussed in the literature. Section 7 concludes. Throughout the chapter, I will use the term ‘producers’ to describe the supply side of a market in which certification occurs and the term ‘consumers’ for the demand side.
2 Markets for Search Goods, Experience Goods and Credence Goods
Since the seminal papers of Nelson2 and Darby and Karni, 3 it is common to distinguish the three types of goods mentioned in the title of this section. Search goods are what economists have in mind when they present the simple model of a competitive market or even a monopoly market. All parties to a contract can easily observe all properties of search goods which the contract covers before it is concluded. Hence, there are no information asymmetries. Any care the seller of such a good takes increases the quality of the good as the buyer observes it. Consequently, additional care increases the buyer’s valuation of the good and thus his willingness to pay too. The seller of the product has thus incentives to increase care and thus the quality of the product as long as the additional costs of care and quality are lower than the additional valuation of the buyer for the good measured in his willingness to pay. There is thus no need for any further incentives for the seller to take care and provide high quality. No regulation is needed, not even liability is required as an incentive to achieve economic efficiency.
Rarely the argument convinces for all properties of a specific good. It is therefore more precise to speak of search properties of a good—and experience properties and credence properties accordingly. However, most of the arguments are more easily presented if one assumes that all goods can easily be allocated to one of the three groups without differentiation with respect to their specific properties. We therefore follow this simplification, which is standard in the literature.
If the buyer cannot observe the qualities of a good before the contract, it is called an experience good or a credence good, depending on whether the buyer can observe properties after having entered into the contract or not even then. In both cases, the argument in favour of economic efficiency of the market is flawed: while additional care does still increase quality (and costs of production), the buyer’s valuation of the product and his willingness to pay are not affected any more. Therefore, taking care and increasing quality cease to be worthwhile to the seller. As Akerlof has shown,
2 Nelson (1970), p. 311.
3 Darby and Karni (1973), p. 67; an often-cited formalization and extension of the argument is Emons (1997), p. 107.
also in 1970,4 any variance of quality in the market tends to break down and so possibly does the entire market due to the problem of adverse selection. Of course, there are ways to overcome these problems, ranging from guarantees given by the seller in order to signal his high quality, reputation, regulation and, not the least, the topic of this chapter: certification as a means to reduce asymmetries of information. All these remedies may substitute each other to some degree, but certification may be the most efficient remedy under certain circumstances. It is therefore helpful to better understand how certification works in detail.
3 The Basic Viscusi Model
Nearly 40 years ago, Kip Viscusi introduced a first model of purely market-based certification as a means to signal high quality of a producer.5 The argument is based on standard signalling theory: High-quality producers of goods approach a (private) certification agency.6 This certifier investigates the quality of the product at some costs, which he charges to the producer demanding certification.7 His investigation technology is rather simple: if he incurs the costs (of a given amount), he receives perfect and complete information on the quality of the product. He then correctly certifies this quality in a way that consumers of the good can fully understand. As a consequence, consumers can and do decide according to their preferences which of the certified products they buy and at which price. Obviously, it is not worthwhile for low quality producers to purchase certification because such certification would not provide any information to consumers that is valuable to the producer. In equilibrium, only and all producers whose products are of a sufficiently high quality will purchase certification, where ‘sufficiently high’ means that the quality induces consumers to be willing to pay more than their average valuation of non-certified products plus the certification costs. From the consumers’ perspective, such certification elucidates the individual quality of all high quality products and the average quality of uncertified low-quality products.
4 Akerlof (1970), p. 488.
5 Viscusi (1978).
6 Stahl and Strausz (2017), p. 1842, discuss the assumption that it is the producers who pay the certifier and not the consumer—an assumption prevailing in nearly all publications on certification. They show that in general, certification purchased by producers is (1) more informative due to the information contained in the decision to certify, which is partly observable and (2) superior from a welfare point of view. The result is reinforced by the argument that certification purchased by consumers may be obstructed by low-quality producers. The only exception to this result is subsidized certification: Stahl and Strausz show their central results hinge on the price for certification being at or above marginal costs of certification.
7 Faulhaber and Yao (1989), p. 65, consider a different type of information producing agents: ‘reviewers’ who are paid by consumers rather than by producers, which turns the model from a signaling to a screening approach. As ‘reviewing’ is empirically much less relevant than certification, this paper concentrates on the latter.
G. von Wangenheim
Obviously, Viscusi’s model was a first step towards understanding certification, but most problems require more complex approaches to be appropriately dealt with. In particular, certifiers may be able to decide on providing correct information on the producers’ quality or not, certification may refer to only a threshold being met, consumers’ preferences may be heterogeneous, multiple certifiers may certify different aspects of goods, and both producers and consumers may exert costly effort to deliberately disguise or discover the true quality of products. The following sections will tackle these problems, many of which the literature has already discussed while others still await careful scrutiny.
4
Opportunistic Certifying Agencies
The simple-most way to allow for opportunistic certifying agencies is to assume that the agency not simply finds and discloses the true quality of the producer’s good, but chooses between three alternative actions after the producer has solicited its services. It may either exert honest effort and thus produce true information on the quality of the good or simply guess the quality without exerting effort or certify the highest-possible quality, again without exerting any effort.8 Depending on how costly it is to verify the certifier’s quality assertion, certification itself becomes an experience good or even a credence good. All problems of asymmetric information, which were at the very basis of any need for certification, re-occur.
Re-occurring problems suggest re-occurring and standard solutions: guarantees or other forms of liability, reputation, regulation and certification. Certification of certifying agencies obviously runs the risk of an infinite regress. To avoid it, one has to argue that there is a tier of certification on which the asymmetric-information problem is solved. Thus, only the other three standard approaches may overcome asymmetric information as a source of fraudulent or negligent certification.
Two reasons exclude that guarantees and other forms of liability work for certifiers. First, it is hard to imagine that guarantees or liability of certifiers can provide reliable information to consumers when guarantees and liability of producers cannot. Second, unless honest certifiers never err on the quality they certify, a guarantee or liability, from which all consumers would have to benefit, would entail tremendous expected costs for the certifier and therefore make certification too expensive a signal.9 One should be aware that this argument holds true for negligence liability as much as it does for strict liability unless one adopts the hardly realistic assumption of perfect information on the standard of care required for certifiers.
Among others, Roland Strausz10 has dealt with reputation of certifiers. An important property of reputation in general is that it relies on the comparison of one-time
8 Biglaiser (1993), p. 212, was the first to mention these possibilities.
9 Biglaiser (1993) circumvents this problem by assuming that certification only refers to a single unit of the good and each and every unit is certified individually.
10 Strausz (2005), p. 45.
gains and long run losses from reneging on one’s quality promise. In a dynamic setting, reputation therefore exhibits substantial economies of scale and economies of scope: the larger a firm and the more products benefit from the same reputation, the more there is to lose from defecting on reputation and thus the more credible a promise to provide high quality becomes. As certifiers specialise in reputation for credibility, their business is most susceptible to the consequences of economies of scale and scope: monopolization of the market, or at least oligopolisation. As Strausz shows, this may raise prices in the certification market even beyond the static monopoly price.
However, the economic literature is far from completely understanding reputation in certification markets as the solution to the asymmetric-information problem. The existing models11 suffer from multiple equilibria, only some of which stabilise reputation and honest certification. Most publications in the field concentrate on these desirable equilibria but fail to give good reasons for this abstraction, nor do they explain how reputation for honest certification grows in the first place.12 Again, the aforementioned economies of scale and scope exacerbate the problem—reputation only becomes stable when it promises future gains for many and frequent cases.
To propose government regulation of certification agencies as an alternative solution to asymmetric information raises questions of the same kind as in other markets. If government wanted to regulate the output of certifiers, it would be hard to imagine why the regulator does not use the information required for such regulation of the certifiers to regulate the certified industry directly. Regulation by liability would suffer from the same problems as discussed before for guarantees. Given the limited information available to evaluate the care that certification agencies take, both a negligence and a strict liability regime would expose the certification agencies to a risk of high-stake liabilities that would very quickly destroy any supply on the market for certification.
Only input regulation, i.e. qualification requirements for the certifiers and requirements of observable signals of high effort that agencies exert to prepare their certification decision, can be administered without essentially suppressing any supply of certification services. Obliging certifiers to employ qualified personnel or proving their competence in some way or other reduces their opportunity costs of handing down high-quality certification decisions.13 Obviously, such input regulation
11 Apart from Strausz (2005) see, e.g. Peyrache and Quesada (2011), p. 1099.
12 Peyrache and Quesada (2011) construct a model, in which the certifiers do not switch immediately from honesty to complete corruption when their time preference becomes too strong, but gradually increase the range of true qualities for which they accept bribes for exaggerating the quality in their report, when the relative value they attach to future profits declines.
13 See Shapiro (1986), p. 843, for a first model studying the effects of input regulation in markets with reputation for output quality. Shapiro considers input regulation in two forms: licensing, i.e. abolition of supply by producers without a minimum education, and certification, i.e. truthful information of consumers about whether a producer has passed the minimum education or not. Note that Shapiro uses the term ‘certification’ for information on input qualification while in this paper I use it for information on output quality, in line with most of the economic certification literature.
G. von Wangenheim
is far from guaranteeing high quality certification, not the least because it also reduces competition between certifiers.14
In addition to the simple model of shirking and collusion with only two or three alternative actions of the certification agency discussed so far in this section, one could explicitly model the probability of the certifier to determine the quality correctly as a function of his effort to avoid such errors. On first sight, this endogeneity of error probabilities does not change much of the argument presented so far. Producers with high quality will still be the ones who request certification and the problems of collusion between producer and certifier remain vivid. However, strategies to overcome incentive problems of certification agencies cannot be as simple as before. As error probabilities cannot be zero with finite effort, optimal strategies of both producers and consumers must be forgiving and somewhat tolerant with respect to misreported quality.15 In such a world, market incentives for producers to produce high quality and for certifiers to exert effort and not to collude with producers necessarily are incomplete. Although to the best of my knowledge no such model of certification exists in the literature, I conjecture that no Nash equilibrium with a socially optimal level of the certifier’s effort or absence of collusion exists, because that would require observation of effort or full internalization of the consequences of errors. Certification therefore will not be a perfect solution to the quality problem. Any lawyer-economist might again be tempted to rely on liability to close the gap between market equilibrium and the social optimum. However, the same obstacles as discussed before will prevent this approach from being successful. Strict liability would entail complete insurance of consumers by certifiers for which hardly any consumer would be willing to pay. Perhaps to a lesser degree but still so, the same would be true for negligence liability due to unobservability of the certifier’s effort and a thus necessarily uncertain standard of care.
5 Certification of Minimum Quality
Leaving aside the aforementioned problems of incomplete information of the certifier, several authors study the causes and effects of minimum quality certification. In these models certificates only refer to whether a good’s quality meets (or surpasses) a certain minimum standard.
Buehler and Schuett follow Viscusi’s original assumption that certificates are truthful information on quality. Minimum standard certification then becomes very similar to public quality regulation. The crucial difference is, of course, that with certification producers may still decide to produce a quality below the minimum standard and that it is the market and not the regulator who decides on whether there
14 Kleiner (2000), p. 189, stresses this problem for occupational licensing in general.
15 See Green and Porter (1984), p. 87, for an early model of enforcement of cooperation with uncertainty in a completely different field (cooperation in a cartel). Ganuza et al. (2016), p. 213, apply the model to quality reputation but not to certification.
is demand for low quality products or not. Buehler and Schuett16 study the effects of such certification in a duopoly market with some but not all consumers uninformed about quality. They show that minimum quality certification is superior to minimum quality regulation when the number of uninformed consumers is large because the latter tends to deter firms from entering into the market. Van der Schaar and Zhang17 show that the existing results do not depend on the crude simplifications of the previous literature but extend to a situation where information of some consumers is not exogenously given, but evolves from reputation over time by Bayesian updating based on stochastically distorted quality observations.
Lizzeri18 endogenises the disclosure strategy of the intermediary in his model. In particular, he assumes that the certifier perfectly observes the quality of a good, but truthfully discloses information on this quality only according to a previously announced rule, which may, for example, be disclosure of the exact quality or only information on whether a certain threshold has been passed. One should note that this assumption also excludes collusion between the producer and the certifier. It turns out that certifiers with market power will restrict the information they disclose.
In the extreme case of a monopolist certifier and quality being a merely stochastic outcome of production costs equal across all producers, information will be restricted to whether quality meets or passes one certain threshold, where this threshold guarantees that socially valuable qualities, i.e. those which consumers value higher than the costs of production, are certified while the others are not. The central argument for this being an equilibrium is that it allows the certifier to maximise his profits. In less extreme cases, disclosed information will be more detailed for high qualities, but there will be no differentiation between the low quality products.
The insights of Lizzeri indicate that certifiers’ policies to only inform about whether quality meets a threshold is not only a tribute to restrictions of consumers’ limited abilities to process detailed information but also originates from certifiers’ profit maximisation.19 Farhi et al.20 and Lerner and Tirole21 have extended the argument to incorporate multiple certifiers with only one threshold for each certifier but different thresholds across them. None of them is interested in revealing the identities of producers who applied for their certificate but failed to meet the standard. Such tiered certification systems also add more costs, and delay, to the provision of information, as producers tend to start high and apply with lower tier certifiers only after having failed to get high-level certification.
16 Buehler and Schuett (2014), p. 493.
17 van der Schaar and Zhang (2015), p. 509.
18 Lizzeri (1999), p. 214.
19 For an overview of further results supporting this claim, see Pollrich and Wagner (2016), pp. 345 and 346.
20 Farhi et al. (2013), p. 610.
21 Lerner and Tirole (2006), p. 109.
The consequences of minimum quality certification on producers’ incentives to exert costly effort for improving quality are quite obvious. If information of certifiers is perfect, producers have no incentive to increase quality unless they are able to surpass the next threshold. If there is only one threshold, only two qualities will remain in the market. If certification is stochastic but higher quality increases the probability to be certified, producers of course also have incentives to improve quality if they are in the vicinity of a threshold. As certification agencies capture some of the additional profits a producer gets from selling certified high quality, voluntary certification cannot induce as strong incentives to produce high quality as perfect information of consumers would.22
6 Open Questions
Despite many steps forward in economic research on certification during the last two decades, understanding of the full complexity of certification in real world markets is still incomplete. Three major open questions are the effects (1) of heterogeneous consumer preferences, (2) of bounded rationality, and (3) of producers’ choice between quality improvement and active concealment of low quality.
Heterogeneity of consumers’ preferences is likely to be covered with minor changes of the existing models when only one quality dimension exists and consumers vary in their willingness to pay for such quality. However, adding more dimensions adds more strategic choices for certifiers as well as for producers. Imagine, for example, a market for a good produced from resources harvested in less developed countries and consumed in industrialized countries. Consumers may, and casual experience shows that they do, care for ecological aspects of resource growing in LDC and of production in the industrialized country, for social circumstances of resource growing and production (e.g. child labour), and for the effects of the final product on consumers’ health. And consumers will care for these aspects to different degrees. Das23 provides a first attempt to analyse certification in a market in which consumers care for more than one quality dimension. Although he models certification only for one dimension, the addition of a second preference dimension seems to alter results dramatically and provide additional insights: non-profit certification becomes superior to for-profit certification if the second dimension of preferences has weak effects on consumers’ choices.24
Such heterogeneity is likely to bring about separate certification agencies, each being responsible for one or very few quality dimensions. Even within one general
22 Albano and Lizzeri (2001), p. 267; Hvide (2009), Article 5.
23 Das (2016), p. 251.
24 The intuition for this surprising result is that non-certification and thus production of low quality may be a means to separate markets and thus collect monopoly rents on both markets. If differentiation by the second quality dimension is large enough, certification is not needed to differentiate products.
G. von Wangenheim
quality aspect with asymmetric information, several certifiers may emerge despite the aforementioned concentration tendencies. Closely competing certification agencies will of course compete on prices they charge to producers but also on the appropriateness of their standards of certification for consumers’ preferences. Given bounded rationality of consumers, even certificates for completely useless or otherwise irrelevant properties, like e.g. ‘produced without labour of white elephants’, may emerge and remain in the market for some time. Economic analysis of such distracting certificates is as much open to further research as the selection of relevant quality dimensions by certifiers.
Surprisingly, nearly all existent economic models of certification completely rely on asymmetric information in a world where consumers are perfectly rational.25 It is well known that bounded rationality is not as easily described in a general model as perfect rationality. Nevertheless, as certification has developed as one major way to reduce information asymmetries it seems to be straight-forward to also include it in models with boundedly rational consumers as an instrument to reduce complexity of information and thus improve decisions of these boundedly rational consumers. Pu and Zhang26 are the only authors so far, who explicitly include bounded rationality in a model of voluntary certification. However, they reduce bounded rationality to the inability of consumers to recognise fraudulent certification in a model of one quality dimension and a given proportion of consumers who are rational and thus identify the quality of the good directly. Problems of bounded rationality related to the multiplicity of quality dimensions remain uncovered in the theory-based literature. Our economic understanding of these problems is still scant.
Finally, a third open field in microeconomic theory in general and the economic discussion of voluntary certification in particular deserves mention here: the aggravation of information asymmetries by producers, and certifiers, of goods. Suppliers in any market may be tempted to spend resources on misleading consumers of their products, be they goods or information, in their perception of quality. The weakest form, still close to the standard approach in asymmetric-information theory, is spending resources on hiding information, which may be described theoretically as the mirror image of not spending resources on disclosing information in a reliable way.27
There are stronger forms of costly misinformation, though. For example, suppliers may, and some do, actively spread information on exaggerated qualities of their products or on qualities they do not have at all. Doing so is of course costly. Bischoff
25 Combining the search words “certification” and “bounded rationality” returns zero entries in EconLit and one for a law journal contribution in SSRN (Becher 2009, p. 747). scholar.google returns more entries, but none on the first pages really combines the two approaches. ISI Web of Science returns one case study (Pelaez et al. 2010, p. 27) and the only theory-based paper by Pu and Zhang (2016), Article No 953.
26 Pu and Zhang (2016).
27 Stahl and Strausz (2017) refer to this problem when comparing producer-purchased and consumer-purchased certification, but their model excludes nearly all other problems discussed in the current paper.
G. von Wangenheim
and Blaeschke28 published one of the few papers in which this social waste of resources is studied explicitly. However, they do not apply their model to general markets for experience or credence goods nor to certification, but refer to costly ‘window dressing’ of local politicians striving for funds from a central government. Applying their approach of using resources either to improve quality itself or to improve merely its presentation and describing the ensuing perception of quality by a function of the two uses of resources to the case of producers would be straight forward and provide a useful starting point for investigating certification in an environment where such information-blurring activities exist. Nevertheless, existing approaches to certification markets until now lack active deception of consumers as a constitutive element. Understanding certification without accepting the existence of this problem seems to neglect a major part of the problem.
7 Conclusions
This chapter has reviewed the literature on voluntary certification provided by private agencies. Starting from the seminal model presented by Viscusi, the focus was first on opportunistic behaviour of certifiers. Both collusion with the producer to be certified and moral hazard of certifiers with respect to their error-reducing effort have been discussed. It turns out that reputation of certifying agencies and government regulation of inputs of certifiers are the only viable approaches to overcome these problems—despite their imperfections due to economies of scale and scope in reputation and the risk of abuse of regulation for restricting entry to the certification market. From the theoretical perspective, reputation of certifiers is disappointing as a solution to the problems insofar as high quality certification is but one equilibrium among several others in most modelling approaches.
Besides problems of opportunism, much of the literature on certification explains the causes and effects of minimum quality certification, which conceals much of the information certifiers acquire when investigating the products to be certified. It turns out that this form of certification is a result of profit maximization of certifiers being contracted by producers. However, this need not be to the disadvantage of consumers as the latter also derive information from the very fact that the producers decide to apply for a certification, or that they do not. In addition, (boundedly rational) consumers tend to understand information contained in minimum quality certification more easily than full quality information.
Economic literature on certification provides many useful results, but it is far from giving all answers one would desire for designing a good legal framework for the certification market. Open questions that the last section of this chapter has stressed are the discussion of preference heterogeneity of consumers with respect to more than one quality dimension, the problems of bounded rationality and the
28 Bischoff and Blaeschke (2016), p. 344.
effects of active distortion of information by producers and certifiers, for example in the form of costly window dressing, which may replace true quality improvements.
References
Akerlof, G. A. (1970). The market for “Lemons”: Quality uncertainty and the market mechanism. The Quarterly Journal of Economics, 84, 488.
Albano, G. L., & Lizzeri, A. (2001). Strategic certification and provision of quality. International Economic Review, 42, 267.
Becher, S. I. (2009). A ‘Fair Contracts’ approval mechanism: Reconciling consumer contracts and conventional contract law. University of Michigan Journal of Law Reform, 42, 747.
Biglaiser, G. (1993). Middlemen as experts. The RAND Journal of Economics, 24, 212.
Bischoff, I., & Blaeschke, F. (2016). Performance budgeting: Incentives and social waste from window dressing. Journal of Public Administration Research and Theory, 26, 344.
Buehler, B., & Schuett, F. (2014). Certification and minimum quality standards when some consumers are uninformed. European Economic Review, 70, 493.
Darby, M. R., & Karni, E. (1973). Free competition and the optimal amount of fraud. The Journal of Law & Economics, 16, 67.
Das, S. (2016). Certification under oligopolistic competition. Environmental Resource Economics, 65, 251.
Emons, W. (1997). Credence goods and fraudulent experts. The RAND Journal of Economics, 28, 107.
Farhi, E., Lerner, J., & Tirole, J. (2013). Fear of rejection? Tiered certification and transparency. The RAND Journal of Economics, 44, 610.
Faulhaber, G. R., & Yao, D. A. (1989). “Fly-by-Night” firms and the market for product reviews. The Journal of Industrial Economics, 38, 65.
Ganuza, J. J., Gomez, F., & Robles, M. (2016). Product liability versus reputation. The Journal of Law, Economics, and Organization, 32, 213.
Green, E. J., & Porter, R. H. (1984). Noncooperative collusion under imperfect price information. Econometrica, 52, 87.
Hvide, H. K. (2009). Oligopolistic certification. The B.E. Journal of Theoretical Economics, 9(1), Article id 5.
Kleiner, M. M. (2000). Occupational licensing. Journal of Economic Perspectives, 14, 189. Lerner, J., & Tirole, J. (2006). A model of forum shopping. The American Economic Review, 96, 1091.
Lizzeri, A. (1999). Information revelation and certification intermediaries. The RAND Journal of Economics, 30, 214.
Nelson, P. (1970). Information and consumer behavior. Journal of Political Economy, 78, 311.
Pelaez, V., Aquino, D., Hofmann, R., & Melo, M. (2010). Implementation of a traceability and certification system for non-genetically modified soybeans: The experience of Imcopa Co. in Brazil. International Food and Agribusiness Management Review, 13(1), 27.
Peyrache, E., & Quesada, L. (2011). Intermediaries, credibility and incentives to collude. Journal of Economics & Management Strategy, 20, 1099.
Pollrich, N., & Wagner, L. (2016). Imprecise information disclosure and truthful certification. European Economic Review, 89, 345.
Pu, X., & Zhang, H. (2016). Voluntary certification of agricultural products in competitive markets: The consideration of boundedly rational consumers. Sustainability, 8(9), Article id 953.
Shapiro, C. (1986). Investment, moral hazard, and occupational licensing. Review of Economic Studies, 53, 843.
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Stahl, K., & Strausz, R. (2017). Certification and market transparency. Review of Economic Studies, 84, 1842.
Strausz, R. (2005). Honest certification and the threat of capture. International Journal of Industrial Organization, 23, 45.
Van Der Schaar, M., & Zhang, S. (2015). A dynamic model of certification and reputation. Economic Theory, 58, 509.
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Challenges for Responsible Certification in Institutional Context: The Case of Competition Law Enforcement in Markets with Certification
Victoria I. Daskalova and Michiel A. Heldeweg
1 Certification as Regulation
How does certification relate to legally prescribed patterns of behaviour of states, markets and civil society and how can a responsible contribution to the workings of these patterns of behaviour be secured? Assuming that certification, at its core, refers to a statement that a certain state of affairs meets a predefined norm, does certification only add (legal) certainty to further legal relations, or does it impact on the nature and pattern of these relations? We believe that because certification is regulation, its mechanisms of standard-setting, monitoring and enforcement1 can and often do have an immediate and profound bearing on basic rules and principles of modes of legal governance, for example on competition law in market context, on the legality principle in a public hierarchy context, and on relationships based on trust in a civil society context. This contextual relevance of certification, as a significant regulatory factor impacting on (basic rules and principles of) modes of legal governance, begs the question what makes for responsible certification. This would be certification that, upon its truth-value, is informative and capable of enhancing the functioning of these modes of governance, such as by remedying knowledge gaps experienced by government regulators and by market actors. However, in reality certification may exacerbate knowledge gaps and lead to additional distortions, thus leading to either government failure or market failure. This contribution aims to demonstrate the
1 Black (2002). According to Black, regulation is ‘a focused and sustained attempt to alter the behaviour of others according to defined standards or purposes with the intention of producing a broadly identified outcome or outcomes, which may involve, as control, mechanisms of standardsetting, information-gathering and behaviour-modification’.
V. I. Daskalova (*) · M. A. Heldeweg Department of Governance and Technology for Sustainability, Faculty of Behavioral and Management Science, University of Twente, Enschede, The Netherlands e-mail: v.i.daskalova@utwente.nl; m.a.heldeweg@utwente.nl
P. Rott (ed.), Certification – Trust, Accountability, Liability, Studies in European Economic Law and Regulation 16, https://doi.org/10.1007/978-3-030-02499-4_3
23
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APPENDIX
BOHR’S THEORY OF THE HYDROGEN SPECTRUM
THE mathematics involved in this theory is so simple that only a very slight acquaintance with elementary dynamics is required in order to understand it.
Let us consider an electron revolving in a circle about the nucleus. Let be the mass of the electron, a the radius of its orbit, its angular velocity. Also let be the (negative) charge on the electron and the (positive) charge on the nucleus.
Then according to elementary dynamics, the centrifugal force of the electron in its orbit is while the force attracting it to the nucleus is by Coulomb’s Law. These two must be equal, so that
So far, we have been proceeding on traditional lines. But we come now to the application of the quantum theory.
The kinetic energy of the electron is ; the potential energy is . In virtue of the above equation, is double , so that the total energy is equal to the kinetic energy with its sign changed. The impulse corresponding to is , and this has to be taken round one complete circuit of the orbit. This yields the value , which must be put equal to a multiple of , say , where is an integer. Thus we have the equation
Now and and are known; thus (1) and (2) determine and as soon as is fixed. We have
The smallest possible orbit is got by putting ; thus its radius is , where
The next possible radius is
The kinetic energy in the orbit is
Since the total energy is the kinetic energy with its sign changed, the loss of energy in passing from the to the orbit is
If this transition is to give rise to a wave of frequency , we must have by the principle of quanta. That is to say is given by the equation
If is the velocity of light, this gives a wave-number . Now the empirical formula for the wave-numbers of the lines of the hydrogen spectrum is
where is Rydberg’s constant. This shows that, if our theory is right, we ought to have
By substituting the observed values for , , , and , it is found that this equation is satisfied. This was perhaps the most sensational evidence in favour of Bohr’s theory when it was first published.
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