ABSTRACT
Buyers in auto repair, health care, and other “diagnosis-cure” markets generally are unable to determine their condition. They can neither perfectly observe nor costlessly verify sellers’ actions or recommendations. A moral hazard problem arises because sellers have an incentive to misrepresent buyers’ condition to increase demand for the treatments they supply. Controlling for differences in vehicles’ characteristics and operating condition, inspection failure rates are more than twice as high in inspections conducted by state officials as in those completed at private firms. By state law, vehicles must receive emission inspections in order to be registered in California. The state licenses individuals to complete inspections and perform emission-related repairs. Inspectors are employed by private firms, which are also licensed by the state. Inspection prices are unregulated. Firms choose their organizational characteristics, whether to supply inspections and prices in order to maximize profits.
