Regulation of charlatans in high-skill professions

The title of this post is also the title of a recent working paper by Jonathan Berk (Stanford) and Jules van Binsbergen (University of Pennsylvania). The paper is theoretical and quite technical, but can be fairly easily summarised (I think) as follows. In many professions, it is possible for unskilled producers (charlatans) to pass themselves off as skilled, and essentially sell a worthless service to consumers. Consider an unskilled real estate agent, or financial advisor, for instance. To protect consumers from this possibility then, governments might require certification (that professionals in these fields must pass some sort of certification test in order to practice), or licensing (that professionals must hold some licence in order to practice). Berk and van Binsbergen show that these requirements may make consumers worse off, because even though the quality of services they receive would increase (by preventing charlatans from providing services), this would be more than offset by reductions in competition between professionals. I'm probably oversimplifying their arguments, which require some deeper thinking to get your head around. Here's what the authors say in the paper:

It is often argued that informing consumers better about the products they buy, leaves them better off, because they can make better choices. However, this logic ignores the equilibrium effect on prices that such information revelation has. Consider the case where the government is perfectly informed about who the charlatans are, and instead of setting standards, simply communicates this information to consumers. It is tempting to conclude that by providing this information, the government will make consumers better off. We prove the opposite. Even though the information fully drives charlatans out of the market, consumers are left worse off. The reason is that once again, there are two price adjustments that follow from such information revelation. First, prices of the remaining professionals will go up to reflect that consumers now have a zero probability of dealing with a charlatan. This leaves consumers indifferent, they pay more, but they get better service. But second, because competition amongst providers is reduced, prices will go up further, and this second effect reduces consumer surplus...

These insights also have important implications for the debate in the economics literature on certification and licensing. The difference between these two regulations is that a professional cannot practice without a license, but can practice without being certified. Consequently, we can interpret a licensing requirement as a minimum standard and certification as requiring information disclosure. The existing literature comes down in favor of certification because it provides consumers with information they otherwise do not have access to... Although the observation that certification reduces competition less than licensing is correct, the argument misses the fact that certification also reduces competition and as a result it also reduces consumer surplus... In summary, in our setting, certification is never preferred, not by producers nor by consumers.

Professionals prefer the licensing rather than certification, because it allows them to increase their own profits (although it reduces total welfare - a classic result of their increasing market power). There isn't much in the way of empirical support in the paper, but I expect this is something that others will follow up on in the future. The paper left me wondering whether having risk averse consumers would make a big difference, and in that case whether licensing or certification may be welfare enhancing given that consumers would be willing to pay to avoid the risk of dealing with a charlatan. The authors allude to this in the final sections of the paper, but I don't think they have fully dealt with this issue.

One last point: I really loved this footnote from the paper:

Even homeopaths and psychic readers have certification boards. One Chief Examiner of The National Certifying and Testing Board of the American Federation of Certified Psychics and Mediums Inc. is specialized in pet communication. On a more existential note, one wonders why a psychic examiner would even need to administer an examination to determine whether a candidate is qualified.

Nice.

[HT: Marginal Revolution, back in June]