A Theory of Optimal Quality Reports with Inertia

Abstract This article investigates optimal quality report design problems in a dynamic context when the service providers have moral hazard problem. I use a two-period repeated contest model between two firms in an attempt to attain a relatively better rating since a better rating leads to a bigger market share. The quality report agency calculates a firm's current rating with the inspected quality of the firm's service and carried-over advantage from the firm's past rating. The size of this advantage is the agency's control variable and models the degree of inertia in the scoring rule. The result shows that how much inertia a scoring rule is required to have, depends on several market characteristics such as the uncertainty in quality production, the consumers switching costs, and the quality investment persistency.