Rather than explicitly revealing information about the quality of their products and services, many firms prefer to signal quality through the prices they charge, typically working on the assumption that a high price indicates high quality. New research by Maarten Janssen and Santanu Roy provides a new explanation for why firms choose not to disclose quality directly – and explains how prices that are set to signal quality can distort actual buying decisions.
Their study, which is published in the February 2015 issue of the Economic Journal, shows that when firms compete on price, not disclosing product quality voluntarily can soften competition and boost profits. This has an important policy implication for regulators: even if consumers infer all relevant product information from prices (or other actions by firms), there may be a case for imposing mandatory disclosure regulation. Such regulation can reduce market power and the price and consumption distortions resulting from firms'' use of prices to signal product quality.
The researchers begin by noting that in a large number of markets, ranging from educational and health services to consumer goods and financial assets, sellers have important information about the quality of their products. Quality attributes include satisfaction from consuming the product, durability, safety and potential health hazards as well as ethical and environmental attributes.
Information about these quality attributes is not always publicly available to potential buyers or competitors. In many of these markets, firms have the option of voluntarily disclosing product information in a credible and verifiable manner – for example, through independent certification, rating agencies or regulated advertising.
But in practice, firms do not disclose product quality very often, even when there are relatively cost-effective mechanisms for credible disclosure and even when the product quality itself is not bad. For example, empirical studies find that hospitals often do not disclose risk-adjusted mortality; schools often do not report standardised test scores; restaurants almost never disclose hygiene inspection reports; and so on.
In fact, the reluctance of firms to disclose voluntarily may discourage the emergence of rating agencies and certification intermediaries in many industries. This study provides a new explanation for why firms do not wish to disclose quality.
The researchers'' explanation is based on the commonplace observation that even when there is no hard and credible information about products on the market, buyers often associate higher prices with better quality and cheap products with low quality.
Such beliefs held by buyers are rational in markets where firms anticipate this and choose their actions (such as prices) to convey the hidden information. Economists call this ''signalling'': it is an alternative way of communicating private information by firms. The researchers argue that firms may not disclose product attributes voluntarily because they find it more profitable to signal their information indirectly.
This is somewhat paradoxical at first glance. Economists have long maintained that signalling is costly for firms. For example, to signal high quality through high prices, a firm may have to charge a much higher price than in a situation where product quality was observed or disclosed, leading to loss of sales and profit. The excessively high price is needed to make it credible to buyers that this could not be a low quality product as the producer of such a product would have lower costs and therefore prefer to sell high volume at low price.
Why then would a firm prefer to signal rather than disclose? The answer lies in the strategic behaviour of firms and market competition. The researchers show that when firms compete on price, not disclosing product quality voluntarily and therefore competing under a ''veil of incomplete information'', can soften competition, leading to higher profits and a more collusive outcome.
Firms'' incentives to lower prices to steal business from their rivals are disciplined by the fact that buyers may associate lower prices with lower quality. The resulting market outcome can be one with higher profits for the non-disclosing firm. The strategic incentive for non-disclosure may be strong even when a firm has a strong competitive advantage in the market.
In contrast with previous research on this issue, the new explanation of non-disclosure is not based on disclosure being too costly or imperfect. The researchers show that no firm may disclose product quality (including the ones with the best product quality), even if the mechanism for voluntary disclosure is almost costless and frictionless.
Their analysis indicates that the absence of voluntary disclosure does not mean that consumers make uninformed decisions; non-disclosure arises precisely when buyers infer quality from the market behaviour of firms.
But markets may well be inefficient as the prices that are set to signal quality distort actual buying decisions. This leads to the important policy implication that there may be a case for imposing mandatory disclosure regulation on firms.
''Competition, Disclosure and Signalling'' by Maarten Janssen and Santanu Roy is published in the February 2015 issue of the Economic Journal. Maarten Janssen is at the University of Vienna and Higher School of Economics (Moscow). Santanu Roy is at Southern Methodist University.