Norman Strunk Professor of Financial Institutions; Professor of Finance
Provost of Northwestern University; First Chicago Professorship in Finance, Kellogg School of Management; Professor of Finance
“Sunlight is said to be the best of disinfectants,” wrote Supreme Court Justice Louis Brandeis on the importance of openness and transparency in society. Such sunlight can be a pretty profitable business strategy, too: companies who are forthcoming with information about the quality of the products they sell are rewarded with superior profits from appreciative customers. But Kellogg faculty Michael Fishman, the Norman Strunk Distinguished Professor of Financial Institutions, and Kathleen Hagerty, Senior Associate Dean for Faculty and Research, argue that secrecy sometimes pays, too. Their work in The Journal of Law, Economics, & Organization analyzes firms’ disclosure decisions taking account of the fact that not all consumers will be able to make sense of the information disclosed.
“According to the standard theory of disclosure, any seller with important private information would find it in their interest to disclose the information,” said Fishman. “If you weren’t willing to disclose it, it must be bad news.” Guided by this reasoning, the push and pull of market forces alone—without regulatory intervention—should lead firms to volunteer information to gain a competitive advantage.
“If someone’s selling you a used car,” continued Fishman, “you ask about the car’s service record. Suppose the seller won’t share it with you. They say, I have the service record but I won’t show you. You conclude that there must be something wrong and you refuse to buy the car. The fact that the purchaser will draw a negative inference if the seller refuses to disclose the information should induce the seller to disclose. This is pretty powerful logic.”
But, said Fishman, “Standard disclosure theory was not empirically successful because we have mandatory disclosure laws all over the place.” Indeed, such regulations have existed for decades. For instance, in 1913 Congress passed the Gould Amendment requiring that food package contents be “plainly and conspicuously marked on the outside of the package.” The Securities Act of 1933 required that companies provide information about themselves and their securities to allow investors to make informed investment decisions.
If disclosure incentives were strong enough to persuade sellers to be open about their products and securities, why do mandatory disclosure rules exist? In thinking about why sellers would not volunteer information and who benefited from mandatory disclosure, Fishman and Hagerty suspected that answers to such questions might be hidden by this key feature of earlier studies: consumers were assumed to always understand the information that sellers disclosed.
“To understand why mandatory disclosure laws were needed, we needed to imagine a setting where voluntary disclosure wouldn’t work. So we relaxed one key assumption and arrived at customers with limited understanding, which we thought was fairly realistic,” said Fishman. The Fishman-Hagerty model breaks customers into two groups, those who have enough technical expertise to understand and use the information that sellers disclose and those who lack the expertise and thus cannot understand or use the information.
Explained Fishman, “I can compare food labels and see that the ingredients and nutritional data are different, but I may not understand the implications of this information for my health. Moreover I can’t simply figure out the answer by tasting the various products.” Fishman and Hagerty also reasoned that the degree to which a consumer values a product is a result of both the quality of the product itself and the consumer’s ability to use the product. Disclosed information can allow expert, informed customers to make better use of the product, which can leave them more satisfied and thus increase the price they are willing to pay. For example, people who understand links between dietary fiber and cancer prevention may be more likely to buy pricey, high-fiber breakfast cereal. In this fashion, the ability or inability to understand and use information about a product can influence a consumer’s decision to pay a certain price for that product.
Fishman and Hagerty model a market in which a seller offers either a high or low quality product. With the goal of maximizing profit, the strategic seller sets a price for the product and also determines whether or not to disclose information about the quality of the product. If disclosure is required by regulation, the seller’s strategic options are limited solely to price setting.
With previous models of disclosure, such pricing decisions were relatively straightforward. If a seller shared the information, then the customers, all expertly informed, knew the product’s quality and could assess how much it was worth, thus capping the price they were willing to pay. Imagine Fishman’s used car salesman, virtuous and haloed, handing over the car’s full maintenance record to a customer who was an expert auto mechanic. In such markets, sellers could not set prices that exceeded the product’s quality.
But if consumers cannot understand the disclosed information, they will be less equipped to judge the quality of the product. Sellers may be able to get some consumers to overpay. Imagine now the sinister used car salesmen with a maintenance record effectively scribbled in an unknown language, inflating the price for a customer who does not know a transmission from a muffler. In markets with uninformed consumers, setting a price that does not correspond to product quality can be a profitable strategy.
Of course, regardless of the meaning of the information, a seller’s mere decision about whether to disclose can have consequences. For example, though uninformed customers cannot understand the label on a package, they may draw a positive inference simply from the fact that the seller is confident enough in the product to volunteer the information (and while an uninformed customer knows that he does not understand the disclosed information, he also knows that there are others who do understand). This may be especially telling in a market in which other sellers remain mysteriously tight lipped about their products. Similarly, if a seller does not share information, both expert and uninformed customers are left in the dark; but knowing that the seller is reluctant to disclose could lead to concerned speculation about the product’s quality, undermining the price that consumers might be willing to pay.
Having established the parameters of their consumers, sellers, and products, Fishman and Hagerty set the model in motion to observe what equilibrium conditions emerge. A seller’s product quality, pricing, and disclosure decisions interact with consumers’ informed or uninformed purchasing decisions.
In markets having sizable proportions of expert, informed consumers the Fishman-Hagerty model predicts that sellers voluntarily share information in seeking greater profits. In this respect, the model emulates earlier work on disclosure. Consider hedge funds, for example. Participation is limited to institutional investors and wealthy individuals, and most information is offered voluntarily with few disclosure requirements. “The presumption is that an investor with five million dollars is probably pretty sophisticated. He can take care of himself,” explained Fishman.
But this model also predicts conditions under which sellers benefit more from secrecy than from disclosure. In particular, these conditions occur when only a small percentage of customers can understand information about a product. Since few customers are savvy enough to use the information and appreciate how highly valuable the product can be, few customers are willing to pay higher prices. So if sharing information about a high-quality product cannot lure a sufficient number of high-paying customers, there is little incentive for sellers to disclose the information. Sellers of low-quality goods also have clear motives to hide information about their products: consumers are more likely to overpay for a product if they cannot really appreciate the poor quality of the product.
Given that sellers will not necessarily volunteer information if few consumers can understand it, Fishman and Hagerty considered the impact of making disclosure mandatory. Their analysis suggests that mandatory disclosure does not impact uninformed consumers, but it benefits the knowledgeable consumers in the market who are able to make better use of—and get more value from—the product. Consumers also benefit if mandatory disclosure stimulates improvements in product quality. Sellers, on the other hard, can see their overall profits hurt as fewer people will overpay for products that are shown to be of low-quality.
The restaurant disclosure ordinance in Los Angeles County is an interesting example (Wall Street Journal, May 29, 2003). Restaurants were regularly inspected and their hygiene conditions were rated. Beginning in 1998, restaurants were required to post their ratings. Said Fishman, “What’s really interesting is that even if you had a high rating you still weren’t putting it on the door.” Once the law required that ratings go on the door, hygiene ratings went up, that is, the restaurants got cleaner. This is a market where the model seems to fit. Consumer understanding of hygiene and public health is relatively limited; many people will not understand the implications of the different hygiene ratings.
While they cannot say here what motivates a company to outright lie and distort (they give the sellers in their model the benefit of the doubt and assume that they are not committing fraud), Fishman and Hagerty make clear that Brandeis’ sunlight is not always a money maker even for companies with nothing to hide.
Wessel, David (2003). “Eatery Report Cards: a Model for Schools?,” Wall Street Journal, May 29.
Fishman, Michael J. and Kathleen M. Hagerty (2003). “Mandatory Versus Voluntary Disclosure in Markets with Informed and Uninformed Customers.” The Journal of Law, Economics, & Organization, 19(1): 45-63.