2/18/2009 Costless Disclosure of Product Quality by Sellers Strategic Disclosure: Some Results from Economic Theory Andrew Daughety Department of Economics and Law School Vanderbilt University Conference on Transparency and Accountability: The Role of Information Disclosure $1.50 OR $$.50 February 6, 2009 - Only one apple is in the box; willingness-to-pay as indicated. - The seller knows which type of apple is for sale, the buyer does not. - Costless for the seller to open the box. Costless Disclosure of Product Quality by Sellers: The Unraveling Result Costless Disclosure of Product Quality by Sellers: The Unraveling Result $1.50 $1.50 OR $.50 $ A seller with the “high” type of apple will want to open the box, so as not to be lumped (“pooled”) with the low type. A skeptical consumer will assume the worst if the box remains unopened. This extends to the case of many quality levels. OR $$.50 Thus: voluntary disclosure occurs, no need for disclosure rules, even in the case of a monopoly supplier. (Grossman, JLE 1981; Milgrom, BellJE1981) 1 2/18/2009 Costless Disclosure of Product Quality by Sellers: The Unraveling Result – Underlying Assumptions $1.50 OR $.50 $ - Veracity and verifiability - Costless disclosure - No N economic i activity ti it needed d d tto produce d or learn quality - Buyer sophistication - Single seller - Selective Disclosure - Problems with Transparency Vertical Quality: Examples and Assumptions Some examples of (vertical) quality: • durability (e.g., mean time to failure) • safety (e.g., likelihood of harm) • consumer satisfaction ti f ti (e.g., ( likelihood lik lih d off satisfaction) ti f ti ) • efficiency in use (e.g., appliance energy demands) Usual case: consumers prefer more to less, full-information firm profits increasing in quality. Veracity and Verifiability • claims,, even if vague, g , are truthful;; • quality is verifiable by third party (contractible). Both assumptions supported by ex ante or ex post enforcement. Costly Disclosure of Quality Costly Disclosure of Quality (II) Production cost of quality constant, but requires pre-sale cost to provide credible quality disclosure (e.g., audit cost). Lowest Highest What if production (or other) costs increase with quality? - Now rational buyers know that the quality being sold affects more than (simply) demand. -Thus Thus, firm pricing can signal information about quality; signaling must be costly to be credible. Lowest Pay audit cost, voluntary disclosure No voluntary disclosure; pooling. “Marginal type of seller”: Difference in profits between: • profit if type could costlessly disclose • average profit of non-disclosing types just equal to disclosure cost. If only value of disclosure is to help higher types charge higher prices, disclosure is viewed as “excessive.” (Viscusi, BellJE 1978; Jovanovic, BellJE1983; Verrecchia, JAcctgE 1983) Highest Pay audit cost, voluntary disclosure No voluntary disclosure; distortionary signaling via other channels. Marginal type of seller Now, with multiple (costly) channels of communicating quality (disclosure, price, warranty, etc.) buyer always learns information. Furthermore, now disclosure is generally “insufficient.” - Mandatory disclosure can benefit consumers, but not efficient. (Daughety and Reinganum, RAND 2008) 2 2/18/2009 Acquisition of Information About Quality Prior to Sale What if the seller must learn the quality of the good? • quality testing; • information acquisition from experts. Further assume that buyers may not know if sellers have learned quality Further, quality. Primary results, assuming veracity and verifiability of quality claims: • Under costless disclosure, if learning is costless and disclosure is voluntary, then the seller will choose to learn and will disclose. • If mandatory, the seller will choose to not learn (and not disclose) whenever it is more profitable to have uninformed buyers. • If testing can improve quality, then voluntary disclosure leads to excessive testing; mandatory disclosure to socially optimal amount. Basic implication: mandatory disclosure, if needed, is likely to require mandatory testing and/or significant liability for selective release. Strategic Competitors What happens if there are competitors? Recent theory has focused on two-seller models. • If sellers know each other other’ss quality type, type costless disclosure is incomplete, though (as earlier) still “excessive.” • If disclosure is costly, there is less disclosure with two sellers than with one. • A recent empirical study of competition among HMOs indicates that increased competition is correlated with reduced disclosure. Disclosure may intensify competition, and firms try to avoid this. This gives an important new role for mandatory disclosure: it may increase competition, lowering prices. (Hotz and Xiao, WP 2005; Jin, RAND 2005; Levin, et. al. JIndE forth.; Board, JIndE forth.) (Matthews and Postlewaite, RAND 1985; Shavell, RAND 1994; Shin, ECMA 2003) Buyer Sophistication Most analyses have assumed sophisticated (skeptical) buyers. • This might be a realistic assumption for corporate buyers, regulators. • It may be a stretch for consumers. • Consumers may y have difficulty: y 1) processing complex information (limited understanding); 2) forming beliefs in lieu of disclosure; or 3) anticipating alternatives/consequences for what the seller is providing. In cases (1) and (2), if a fraction of the buyers are not “sophisticated” then even if disclosure is costless, it may not occur. Then mandatory disclosure helps those buyers who can understand disclosed information, at the expense of the seller. Case (3) might be addressed via informational campaigns or by mandating provision of information on alternatives by sellers. (Milgrom & Roberts, RAND 1986; Fishman & Hagerty, JLEO 2003; Daughety & Reinganum, JITE 2008) Partial Disclosure – Selective Release of Information If the buyer knows that there are multiple pieces of information about the product, then strong skepticism again implies that any unrevealed information will be assumed to be worse than that reported. This forces the seller to reveals the best attributes possible. possible • If the seller can only credibly report on a limited set of items, the best ones will be selected. More importantly, this can mean that if only limited disclosure of a series of tests is possible, then limiting discretion as to which tests can be reported can improve the information that is provided. • That Th is, i providing idi uniform if reporting i requirements i can be b socially i ll desirable. This relied on the buyer knowing what the missing reports could have said. This may be unrealistic. (Milgrom, BellJ 1981; Fishman and Hagerty, QJE 1990) 3 2/18/2009 Some Problems with Disclosure/Transparency If disclosure costs are high, since signaling via other channels is distortionary, then both sellers and buyers may be better off with no testing. There can be unintended responses to disclosure. Of course, there is a difference between some inscrutability and no oversight. Privacy considerations • Price discrimination via later use or sale of information revealed via purchase. • Broader privacy considerations (e.g., health choices, reading choices, investment choices, travel choices, contributions). 4