Certification of Socially Responsible Behavior: Eco-Labels and Fair-Trade Coffee

An intriguing alternative to traditional methods for regulating externalities is the provision of information about firms' environmental attributes. An increasingly important example of this approach is "eco-labeling," where a third party certifies firms' products. This sort of approach can also be used in similar circumstances, for example providing consumers with information on the techniques used to produce the good in question (e.g., shade-grown coffee) or the nature of rent-sharing arrangements that govern the transaction (e.g., fair trade coffee). I present a model of this phenomenon. An important aspect of this scheme is that the product in question is typically a credence good (buyers cannot infer product quality from search or consumption), and hence must rely on a third-party for information about the product. But the very fact that consumers cannot infer quality from consumption implies they cannot infer accuracy about the signal; indeed, the certifying agency may not be able to perfectly determine quality at a reasonable cost. As such, the certification process is potentially noisy, albeit with green firms more likely to pass than brown firms. While it is likely to increase the fraction of green units in the market, the introduction of eco-labeling can either increase or decrease welfare. In addition, expected profits earned by green sellers are likely to be more variable in an equilibrium with certification. The paper provides some casual empirical evidence from Latin American coffee markets as a backdrop to the theoretical results.