Eco-Labeling and Market Equilibria with Noisy Certification Tests

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. Such schemes are currently used in a variety of countries. This paper investigates the equilibria that may occur with eco-labeling, and the attendant welfare effects. I model certification as a noisy test, subject to both type I and type II errors, but where green firms more likely to pass than brown firms. While it commonly leads to an increase in the fraction of green units in the market, the introduction of an eco-label can either increase or decrease welfare.