When market unraveling fails and mandatory disclosure backfires: Persuasion games with labeling and costly information acquisition

Abstract

In this paper, we develop a variant of the persuasion game by Milgrom and Roberts to study the emergence and the desirability of product labeling when buyers can acquire information on the quality of the product by paying a cost. Labeling is modeled as the (verifiable) public disclosure of an otherwise unobservable trait of the seller that is correlated with the quality of the product. Our main finding is that market unraveling can fail, in which case imposing mandatory disclosure can backfire. When the joint distribution of seller's qualities and traits is exogenous, if market unraveling fails and mandatory labeling is imposed, then profits decrease for high‐quality sellers and, if the label is sufficiently informative, buyers are better off and profits increase for low‐quality sellers as well. When, instead, the joint distribution of qualities and traits is endogenous, mandatory labeling fails to yield an increase in average quality and buyers' utility, while cost inefficiencies arise.