Consumer Beliefs and Buyer and Seller Behavior in the Vehicle Inspection Market

Moral hazard exists in diagnosis-cure' markets because sellers have an incentive to" shade their reports of buyers' condition to increase the short-run demand for the treatments they" supply. The California vehicle emission inspection market offers a rare opportunity to examine" how incentives operate in such markets. This paper investigates why sellers help vehicles pass" inspections, focusing on multiperiod mechanisms such as those in reputation models. I show that" the demand individual firms face is sensitive to inspection outcomes. Consumers are 30% more" likely to return to a firm at which they previously passed than one at which they previously" failed. If, over the long run, an independent garage fails one additional vehicle per month decreases demand by 5.6 inspections per month on the average. This figure is lower for service" stations and new car dealers. Consumers' behavior is consistent with a learning model in which" they have diffuse initial priors regarding the probability they fail at individual firms Bayesian update using two to three inspection outcomes at each firm.