Potential competition and quality disclosure

• Date: 01 November 2019
• Author: Frederick Dongchuhl Oh,Junghum Park
• DOI: http://doi.org/10.1111/jems.12326
• Published date: 01 November 2019

J Econ Manage Strat. 2019;28:614–630.wileyonlinelibrary.com/journal/jems614

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© 2019 Wiley Periodicals, Inc.

Received: 20 June 2018

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Revised: 27 May 2019

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Accepted: 29 May 2019

DOI: 10.1111/jems.12326

ORIGINAL ARTICLE

Potential competition and quality disclosure

Frederick Dongchuhl Oh

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Junghum Park

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1

KAIST College of Business, Korea

Advanced Institute of Science and

Technology, Seoul, Korea

2

Department of Economics, University of

Essex, Colchester, UK

Correspondence

Frederick Dongchuhl Oh, KAIST College

of Business, Korea Advanced Institute of

Science and Technology, 85 Hoegi‐Ro,

Dongdaemoon‐Gu, Seoul 02455, Korea.

Email: dcoh415@kaist.ac.kr

Abstract

This study presents a model of quality disclosure in which an incumbent,

through its quality and disclosure choices, influences the potential that a new

entrant enters the market. In this regard, we consider a sequential framework in

which the incumbent chooses its quality and decides whether to disclose it to

the market; subsequently, the entrant makes the same decisions, if it enters the

market. We show that the potential competition can create strategic incentives

for the incumbent to choose nondisclosure, because the availability of

information about the incumbent’s quality promotes entry by enhancing the

entrant’s expected profit from the market. In addition, an analysis of the effects

of mandatory disclosure laws suggests that they can be effective in encouraging

new market entrants and in improving the product quality of established firms.

KEYWORDS

mandatory disclosure law, market entry, potential competition, product quality, voluntary

disclosure

JEL CLASSIFICATION

D43; L13; L15

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INTRODUCTION

Firms often have many ways to disclose private information about product quality to consumers without incurring

significant costs. These range from product reviews (e.g., consumer reports) and advertisements to third‐party

certification. More important, the advent of the Internet significantly enhanced the scope and credibility of seller

information disclosure by providing a platform for consumer reviews (Chen & Xie, 2008). Early analyses of quality

disclosure suggest that complete voluntary disclosure occurs because high‐quality sellers are always willing to

distinguish themselves from low‐quality sellers (Grossman, 1981; Grossman & Hart, 1980). However, voluntary

disclosure does not appear to occur as frequently as this type of theory suggests. The extant marketing literature reports

the lack of product information in advertisements (Abernethy & Butler, 1992; Abernethy & Franke, 1996). The fact that

mandatory disclosure laws affect the industry is also inconsistent with this theory. Examples include hygiene ratings for

restaurants (Jin & Leslie, 2003) and the service quality of health maintenance organizations (Jin, 2005).

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In addition,

several recent papers attribute nondisclosure behavior to the strategic interaction among firms due to product market

competition. In particular, high‐quality sellers may decide not to disclose product quality to reduce price competition.

For example, nondisclosure can play a role in differentiating the firms’products from rival products (Board, 2009; Hotz

& Xiao, 2013). Further, a high‐quality firm can use nondisclosure to credibly precommit and not undercut prices, as it

enables the firm to signal quality through higher prices (Janssen & Roy, 2015). However, all of these studies consider

“actual”competition among established firms.

As such, this study considers the effect of “potential”competition on quality disclosure. Given that a market is often

highly concentrated due to economies of scale, patent protection, the presence of a highly rapid innovator, and so on,

potential competition plays a competition‐like role in restraining firms’pricing behavior. In addition, it is well‐known

that potential competition generates an incentive for a monopoly incumbent to deter new competition through a variety

of strategic instruments, such as limit pricing (Milgrom & Roberts, 1982) and capacity commitment (Dixit, 1980), as

well as R&D and advertising (Fudenberg & Tirole, 1984).

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We extend this long‐held idea to answer the question of

whether potential competition affects firms’disclosure behavior. Our insight is that a potential entrant can use the

incumbent’s disclosure for its postentry product positioning, thereby promoting its entry, an unfavorable situation for

the incumbent. This creates the incentive for established firms to choose nondisclosure. We illustrate this insight by

considering the case in which a firm chooses its quality and subsequently decides whether or not to disclose it, a

scenario that is new to the literature on quality disclosure.

We develop a simple model of quality disclosure in which an incumbent makes strategic choices on quality and

disclosure to influence the likelihood that a new entry will occur thereafter. We assume that product quality may be

either high or low, and is unalterably once determined, and that consumers differ in their willingness to pay for each

type of quality. At the start of the model, the incumbent chooses its quality and incurs quality‐dependent fixed costs.

Then, it decides whether to credibly disclose the quality to the market, which has no direct costs. Next, a potential

entrant decides whether to enter the market and incurs entry costs. Upon deciding to enter, the entrant chooses its

quality and incurs the same quality‐dependent fixed costs as does the incumbent. Subsequently, both firms

simultaneously make their postentry disclosure choices. Finally, the firms engage in price competition and earn their

profits accordingly. We assume that a high‐quality premium exists; that is, a high‐quality firm earns a higher profit than

does a low‐quality firm when these firms compete. This is the case when the fixed cost of choosing high quality is

positive, but sufficiently low.

The main result of this study shows that a unique equilibrium can exist, in which the incumbent does not reveal its

quality to the market before entry occurs. With this equilibrium, the incumbent follows a mixed strategy of quality

choice; hence, the quality may be either high or low. However, the incumbent does not reveal its quality to the market

before entry because the incumbent chooses not to disclose it. Moreover, the entrant uses a mixed strategy for the entry

decision, and therefore may or may not enter the market. Once entry occurs, the incumbent discloses its quality. The

intuition behind the incumbent’s nondisclosure behavior is that nondisclosure makes it impossible for a potential

entrant to determine the more profitable quality level, thereby deterring entry. We identify the condition under which

this nondisclosure equilibrium exists and show that it corresponds to an intermediate range of entry costs. In this

regard, within a moderate range of entry costs, there is no equilibrium when the incumbent discloses its quality before a

new entry. The results indicate that firms are likely to reduce disclosure and informative advertising when facing entry

threats. Finally, we compare this equilibrium outcome with the case in which there is a mandatory disclosure law. We

find that enforcement leads to the increased potential of a new entrant in the market, as well as a higher expectation of

quality from the incumbent.

Examples that are in line with our results include manufacturing products and products associated with health and

environmental concerns, including the restaurant industry, as in Jin and Leslie (2003). These industries are often

concentrated or segmented by geography or other horizontal attributes such that no major firm has a head start, but

faces a significant threat of new market entrants. Consequently, though the major firm has a significant market share, it

faces significant potential competition due to the possibility that new firms will enter the market by differentiating

themselves enough to survive, thereby taking the major firm’s market share. Our main result on the incumbent’s

disclosure behavior explains why existing firms in these industries may be reluctant to voluntarily enhance market

transparency. Indeed, Apple, which some refer to as the first mover in its industry, appears to be reluctant to reveal

detailed specifications for its new phones. Addition, in relation to Jin and Leslie’s (2003) study, this result helps to

explain why restaurants were reluctant to disclose their hygiene grades before the adoption of mandatory disclosure.

Further, our results explain why disclosure programs affect these industries, and provide a new rationale for mandatory

disclosure laws. Whether these industries indeed face fiercer competition following mandatory information disclosure

or some external improvement in the provision of information on product quality is an interesting question for future

empirical research.

We contribute to the recent literature on product information disclosure by introducing a new explanation for

nondisclosure phenomena, and showing that mandatory disclosure law benefits consumers by promoting competition

among sellers. The literature considers various aspects of firms’disclosure incentives, indicating the positive and

negative effects of mandatory disclosure laws. While some of these studies suggest that buyer‐side informational

OH AND PARK

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