Incentives of low‐quality sellers to disclose negative information

• Author: Dmitry Shapiro,Seung Huh
• Date: 01 February 2021
• Published date: 01 February 2021
• DOI: http://doi.org/10.1111/jems.12401

J Econ Manage Strat. 2021;30:81–99. wileyonlinelibrary.com/journal/jems © 2020 Wiley Periodicals LLC

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81

Received: 15 March 2019

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Revised: 8 July 2020

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Accepted: 28 July 2020

DOI: 10.1111/jems.12401

ORIGINAL ARTICLE

Incentives of low‐quality sellers to disclose negative

information

Dmitry Shapiro

1

|Seung Huh

2

1

Department of Economics, College of

Social Sciences, Seoul National University,

1 Gwanak‐ro, Gwanak‐gu, Seoul, South

Korea

2

College of Business Administration,

Incheon National University,

119 Academy‐ro, Yeonsu‐Gu,

Incheon, South Korea

Correspondence

Seung Huh, College of Business

Administration, Incheon National

University, 119 Academy‐ro, Yeonsu‐Gu,

Incheon 22012, South Korea.

Email: shuh@inu.ac.kr

Funding information

Incheon National University,

Grant/Award Number: 2017;

National Research Foundation of Korea,

Grant/Award Number: NRF‐

2018S1A5A8027545; The Department of

Economics at Seoul National University;

Creative‐Pioneering Researchers Program

(Seoul National University)

Abstract

The paper studies incentives of low‐quality sellers to disclose negative in-

formation about their products. We develop a model in which one's quality can

be communicated via cheap‐talk messages only. This setting limits the ability

of high‐quality sellers to separate, as any communication strategy they pursue

can be costlessly imitated by low‐quality sellers. We study two factors that can

incentivize low‐quality sellers to communicate their quality: buyers' loss

aversion and competition. Quality disclosure reduces buyers' risk, thereby

increasing their willingness to pay for the product. It also introduces product

differentiation, softening the competition.

1|INTRODUCTION

Is honesty the best policy for sellers? Arguably, when customers cannot easily discover negative aspects of the products,

low‐quality sellers would be better off concealing information about their weaknesses. Many empirical studies have

documented instances where negative information damages sales and purchasing likelihood through various routes, such

as publicity, customer reviews, or word of mouth (Berger, Sorensen, & Rasmussen, 2010). Therefore, it seems natural for

sellers to hide negative information about their products in the presence of asymmetric information aboutproduct quality.

However, we do observe many sellers voluntarily sharing negative aspects of their products, even when customers

would not likely discover them (i.e., when products are high in experience or credence attributes). For example, Hans

Brinker Hotel in Amsterdam, the Netherlands is famous for its strategy of honestly revealing its low quality and

explaining negative aspects of its services, such as rooms without a view and no hot water. Chipotle Mexican Grill's

website used to highlight drawbacks of their ingredients in its “Room for Improvement”section.

1

The website

Woot.com (owned by Amazon) is known for its preemptive revelation of the disadvantages of listed products, stating

that they would prefer that customers not buy from them to “regretting their purchases.”

2

Voluntary disclosure of

negative information regarding experience or credence attributes can also be found in many consumer‐to‐consumer

online marketplaces. eBay and Craigslist sellers often voluntarily describe weaknesses of their listed products, both via

cheap‐talk messages, such as “the product is in fair condition,”and via verifiable information, such as pictures of

specific damages and scratches that are otherwise indiscernible. Jin and Kato (2006) found that many eBay sellers of

collectible baseball cards revealing low grades were honest about their claims, even though most buyers could not

correctly evaluate the quality before or after their purchase. Finally, two‐sided advertising where advertisement in-

cludes negative information—in conjunction with positive claims—about the product is a well‐known practice among

sellers (Crowley & Hoyer, 1994; Eisend, 2006,2007).

Interestingly, voluntary disclosure of negative information does not necessarily originate from reputation concerns.

Craigslist sellers often reveal negative information about their listings even though there are no reputation‐building

mechanisms (like, the one at eBay.com), and most sales on Craigslist are one‐time interactions with no repeated‐game

incentives for being honest. Furthermore, disclosure of negative information does not necessarily have negative effects

on profits or customers' perception of the product. For example, many travelers visiting Amsterdam choose to stay at

Hans Brinker Hotel and leave positive reviews, such as “For the reputation of the world's worst hotel, it wasn't as bad as

I thought.”

3

Two‐sided advertising has been shown to “enhance source credibility, positive cognitive responses, per-

ceived novelty, attitude toward the brand, and purchase intention.”(Eisend, 2006, p. 191).

Although the phenomenon of sellers disclosing negative information about their product is not as uncommon as one

would expect, it has not received much attention in the academic literature, especially from a theoretical perspective, as

the extensive literature on information disclosure has focused primarily on the tension between consumers who want

more information about quality and low‐quality sellers who would prefer to hide such information (Dranove & Jin, 2010).

This paper attempts to fill this gap by investigating the incentives of low‐quality sellers to disclose, rather than conceal,

negative information about their products.

For this purpose, we consider a model in which loss‐averse buyers cannot evaluate the quality of the product, and the

only tool that sellers can use to communicate information about their product's quality is cheap‐talk messages. There are

no repeated purchases, no reputation concerns, no certification technology, and no warranties. The cheap‐talk setting

limits the ability of high‐quality sellers to separate, as any communicationstrategy they employ can be costlessly imitated

by low‐quality sellers, thereby shifting the focus to incentives of low‐quality sellers' in any information transmission.

4

In this setting, we identify two factors that can incentivize low‐quality sellers to reveal their quality in our model.

First, revealing one's quality, whether it is low or high, reduces the quality uncertainty associated with the purchase and

increases loss‐averse buyers' willingness to pay. The literature has generally agreed that quality uncertainty has a major

negative influence on customers' purchase decisions (Bauer, 1960; Dowling, 1986; Markin, Jr., 1974; Ross, 1975; Stone &

Winter, 1985; Taylor, 1974). In an online setting, Dewally and Ederington (2006) showed empirically that uncertainty

reduction increases the valuation of listed products on online auctions. Second, revealing one's quality allows a seller to

differentiate one's product from those of competitors, thereby softening the competition and increasing one's profits. Jin

and Sorensen (2006) have shown that hospitals' decisions to disclose quality scores, whether positive or negative, are

driven by incentives to differentiate themselves from competitors.

To separate the roles of these two factors—uncertainty reduction and softening competition via product

differentiation—we first consider the setting of a monopolistic seller and then extend it by adding a second seller. In the

monopoly setting, when a low‐quality seller decides whether or not to separate, he faces the trade‐off between

the positive information effect of removing quality uncertainty, thereby increasing buyers' willingness to pay, and the

negative quality effect of revealing his low quality, thereby decreasing buyers' willingness to pay. The information effect

must offset the quality effect in order for separation to occur, and we derive conditions for this to happen in equili-

brium. As one would expect, only low‐quality sellers can separate in equilibrium. High‐quality sellers do not face a

trade‐off between the quality and information effects, as the separation would both reveal their high quality and remove

quality uncertainty. Therefore, low‐quality sellers always find it optimal to imitate them.

In the duopoly setting, incentives of low‐quality sellers to separate change since profits depend not only on buyers'

willingness to paybut also on the intensity of competition. If a message associated with higher quality is likely to result in

a more intensive competition, it weakens the incentives of low‐quality sellers to pool with high‐quality types. This means,

as we will show, that equilibria in the duopoly setting include outcomes that were not possible in the monopoly setting.

Overall, this study contributes to the literature on information disclosure by focusing on the incentives of low‐

quality sellers to reveal negative information. First, we show that even when the ability to communicate one's quality is

limited to cheap‐talk messages, and when there are no market frictions, such as search or matching, information

transmission is possible. Second, due to the limited ability of high‐quality sellers to communicate their quality, the

information transmission is driven by the incentives of low‐quality sellers. Third, we identify two factors—buyers' risk

attitude and increased product differentiation—that can incentivize low‐quality sellers to separate. We analyze the role

of each factor on information disclosure and show how they interact with each other.

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SHAPIRO AND HUH