Scandinavian Working Papers in Economics

Discussion Papers,
Norwegian School of Economics, Department of Business and Management Science

No 2004/10: A Theory of Certification with an Application to the Market for Auditing Services

Hans K. Hvide ()
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Hans K. Hvide: Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration, Postal: NHH , Department of Finance and Management Science, Helleveien 30, N-5045 Bergen, Norway

Abstract: The paper develops a theory which attempts to understand segmentation and fee-setting in certification markets. The basis for the theory is that certifiers offer differentiated tests; for a given object it may be more difficult to pass the test of certifier i than the test of certifier j. Given the test standards, certifiers compete for customers via their fee-setting. In equilibrium, sellers with low unobservable quality self-select to a lenient test and sellers with high unobservable quality self-select to a stricter test. Moreover, sellers selecting an easy test pay a lower (endogenous) certification fee than sellers selecting a difficult test. As a test of the theory, I analyze Norwegian panel data to investigate whether firms affilated with a cheaper or a non-Big 5 auditor have worse (unobservable) characteristics, measured by subsequent drops in sales, assets or equity. The empirical analysis supports the theory.

Keywords: Adverse Selection; Auditing; Investment Banking; Oligopoly theory; Signaling

JEL-codes: G24; M42

39 pages, August 26, 2004

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