Journal of Economic Literature 2010, 48:4, 935–963 http:www.aeaweb.org/articles.php?doi=10.1257/jel.48.4.935 Quality Disclosure and Certification:
Theory and Practice
David Dranove and Ginger Zhe Jin*

This essay reviews the theoretical and empirical literature on quality disclosure and certification. After comparing quality disclosure with other quality assurance mechanisms and describing a brief history of quality disclosure, we address two sets of theoretical issues. First, why don’t sellers voluntarily disclose through a process of “unraveling” and, given the lack of unraveling, is it desirable to mandate seller disclosure? Second, when we rely on certifiers to act as the intermediary of quality disclosure, do certifiers necessarily report unbiased and accurate information?
We further review empirical evidence on these issues, with a particular focus on healthcare, education, and finance. The empirical review covers quality measurement, the effect of third-party disclosure on consumer choice and seller behavior, as well as the economics of certifiers. ( JEL D18, K32, L15, M31)

1. Introduction

A

young couple expecting their first child might consult healthgrades.com hospital rankings to help choose where to deliver their baby. A year later, the couple decides they need an SUV and consults performance specifications provided by manufacturers and reads Consumer Reports to learn about reliability. Soon thereafter, the couple obtains test score results from several school districts to help choose where to raise their family. When their child is in high school, they peruse U.S. News and World Report’s rankings of universities. Once their child is off to college, they plan for retirement by investing in AAA-rated corporate bonds and
* Dranove: Northwestern University. Jin: University of
Maryland and NBER.

935

browse through Medicare’s Nursing Home
Compare to help plan for their parents’ final years. Literally from cradle to grave, consumers rely on quality disclosure to make important purchases. Although disclosure has a long history that we describe below, it has attracted considerable attention in the past few years, especially in the areas of healthcare, education, and finance. Quality reporting is a key component of the recently enacted healthcare reform legislation. The No Children
Left Behind initiative relies on testing and disclosure to evaluate and, potentially, punish, underperforming public schools. Many states have similar programs. And much of the finger pointing for the recent crisis on
Wall Street has been directed at corporate bond rating agencies that seemed to ignore systematic risk while giving firms clean bills

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Journal of Economic Literature, Vol. XLVIII (Deccember 2010)

of health. Many policy analysts in these and other industries believe that we need more and better disclosure.
In this essay, we review the theoretical and empirical literature on disclosure. Section 1 compares quality disclosure with other quality assurance mechanisms and offers a brief history of disclosure. In section 2, we address two sets of theoretical issues: first, why don’t sellers voluntarily disclose through a process of “unraveling” and given the lack of unraveling, is it desirable to mandate seller disclosure? Second, when we rely on public or private certifiers to act as an intermediary of quality disclosure, do certifiers necessarily report unbiased and accurate information?
Section 3 discusses empirical evidence on disclosure with a particular focus on healthcare, education, and finance. We begin with a practical question: How is quality measured and reported? We then present evidence that unraveling often does not occur in practice, thereby creating a need for third-party disclosure. We review whether third-party disclosure helps consumers make better choices and whether it encourages sellers to improve quality. We also identify situations where sellers exploit private information so as to boost their ratings at the expense of consumers. We conclude the review of empirical evidence by examining the behavior of certifiers. Section 4 concludes with suggestions for further research.
1.1 Disclosure versus Other Quality
Assurance Mechanisms
We define quality disclosure as an effort by a certification agency to systematically measure and report product quality for a nontrivial percentage of products in a market. While we are mainly interested in thirdparty disclosure, we also include direct quality disclosure by sellers, provided that the disclosed information can be independently verified. This definition distinguishes disclosure from broader marketing efforts by

sellers that do not contain verifiable product information. It also distinguishes disclosure from forums such as town squares, barber shops, or, more recently, Internet sites such as Angie’s List where individuals share wordof-mouth reviews of local service providers without systematic editing and scoring. The latter distinction is admittedly blurry; ratings such as Amazon.com’s customer reviews have elements of both a “town square” forum and a systematic report card.
Quality disclosure can take many forms.
Sellers may voluntarily report product attributes. For example, a hospital may disclose that the majority of its medical staff is board certified. Or an auto manufacturer may report performance specifications. An industry concerned about the lemons problem may establish a certification agency to collect and disseminate product information. Examples include the Joint Commission on the
Accreditation of Healthcare Organizations
(JCAHO), which reports the frequency of
“sentinel events” (instances of poor quality) at member hospitals, and the Motion Picture
Association of America, which is responsible for the familiar G/PG/PG-13/R/NC-17 movie rating system. In these cases, sellers have the choice of disclosing or not disclosing quality information via the certification agency. Those that choose to disclose often pay a fee to cover the cost of certification.
Many industries face mandatory disclosure, whereby a regulatory body requires sellers to disclose certain product attributes in a standard format. In some cases, sellers must provide verifiable information to a designated agency (e.g., automobile manufacturers measure fuel economy and report the results to the U.S. Environmental Protection
Agency). In other cases, government officials inspect the product on site (e.g., a local health board inspects restaurant hygiene).
Mandatory disclosure often focuses on health and safety issues and ignores other product attributes that might influence demand.

Dranove and Jin: Quality Disclosure and Certification
For example, the U.S. Food and Drug
Administration requires food manufacturers to report nutritional information but does not evaluate taste. In recent years, U.S. government agencies have expanded disclosure to include many other factors that can influence demand, including mortality rates for hospitals, on-time arrival rates for airlines, graduation rates for high schools, and consumer satisfaction with Medicare Advantage health insurance plans. There are similar disclosure requirements in many other nations.
The targeted audience has also shifted from government officials who might fine or even shut down a business that failed inspection to the consumers whose demands will determine the fate of low scoring firms. By posting results online and publicizing them through the media, government certifiers hope to ensure that consumers can access the disclosed information with little cost and in a timely manner.
In addition to industry-sponsored voluntary disclosure and government-enforced mandatory disclosure, many private thirdparty certifiers adopt disclosure regimes to satisfy market demand for quality information.1 Examples include the Leapfrog
Group’s hospital quality ratings, Moody’s bond ratings, Consumer Reports’ evaluation of consumer products, and U.S. News
& World Report’s ranking of colleges. Some of these third parties (e.g., Leapfrog) must obtain data directly from sellers and therefore require seller participation. Others may use public information (e.g., U.S News) to evaluate the products and do not require seller participation. In some cases, certifiers may be financially affiliated with sellers, introducing a conflict of interest. Stock analysts working for a brokerage firm that

1 Demand for quality information is usually stronger for credence goods because consumers have difficulty assessing their quality via search or experience.

937

underwrites initial public offerings are often cited as an example of such conflict.
Aside from disclosure, there are many other well-known mechanisms for informing consumers about product attributes. We will call these “quality assurance” mechanisms, though in some cases they provide information about horizontal product attributes rather than vertical quality dimensions. Table
1 gives examples of the mechanisms used to help assure quality in a wide array of markets. All of these markets can be considered credence goods and many are experience goods, in that consumers may find it difficult to evaluate quality of all of these goods prior to purchase but may be able to assess quality of some of them after purchase.
As suggested by table 1, brand and experience are perhaps the most common quality assurance mechanisms, but they are rarely sufficient. One limitation is that, even with experience, consumers may find it difficult to link ex post product failure with a product defect; think of a automobile owner establishing the reason for premature brake wear or a hospital patient determining whether the medical staff is responsible for an adverse outcome. Experience and word-of-mouth are also of limited value when products are infrequently purchased, such as open heart surgery and executive education. Disclosure has the potential to overcome these limitations because certifiers may have better expertise evaluating the product2 and they can aggregate experiences from many idiosyncratic consumers.
Branding, another common quality assurance mechanism, is usually initiated and maintained through the seller’s arketing m 2 Gary Biglaiser (1993) has made the point that intermediaries may have better expertise in evaluating product quality than final consumers. However, the intermediaries in Biglaiser (1993) participate in the buying and selling of the product as a middleman, but a typical certifier in our context is only an intermediary of information and does not buy or sell the product directly.

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Journal of Economic Literature, Vol. XLVIII (Deccember 2010)

TABLE 1

Quality Assurance Mechanisms Used in Various Markets

Brand

Experience/ word of mouth Warranties

Airlines
Appliances
Automobiles
Consumer
electronics

X
X
X
X

X
X
X
X

X
X
X

Hospitals
Lawyers
Movies
Plumbers
Restaurants
Universities

X
X
X

X
X
X
X
X
X

Industrysponsored voluntary disclosure

X
X

Third-party disclosure X
X
X
X

X

X

X

X4

X
X1

X2

X
X

X
X
X

Governmentmandated disclosure Licensing

X
X3
X

Notes: 1 Fuel economy standards and other safety standards. 2 Several states and the federal Medicare program publish quality report cards. 3 Notably, health and safety inspections. 4 A number of regional and national accreditation agencies accredit universities, colleges, and vocational programs for postsecondary education.

efforts. It is unclear whether branding acts as a “bond” in which the seller sinks an investment in branding to signal its high quality or whether branding makes it easier for consumers to recall their positive experiences when making repeat purchases.3 In any event, consumers may find third-party disclosure more trustworthy than brands.
In some cases, sellers may offer warranties, especially if the value of the product is large relative to the cost to consumers of exercising the warranty. Thus, we see warranties for automobiles and televisions, but not for diapers or light bulbs. Warranties are also uncommon for professional services because

consumers have difficulty gauging service quality even after consumption.4 Warranties for hospital care are almost unheard of, for example. Compared with disclosure, warranties often focus on narrow aspects of product performance, such as complete failure, and may not assure gradations of quality.
While most quality assurance mechanisms directly assure product quality, licensing focuses on inputs (e.g., training or staffing) rather than outputs. Licensing is usually done by a government agency, but some industries do their own credentialing. A good example is JCAHO hospital credentialing.
Many insurers refuse to reimburse for

3 See Kyle Bagwell (2007) for a summary of advertising literature. 4 As an exception, plaintiffs’ attorneys in some litigation cases work on a strict contingency basis.

Dranove and Jin: Quality Disclosure and Certification

939

s ervices performed at noncredentialed hospitals. Sometimes government agencies may also establish a minimum quality standard that measures quality directly but does not differentiate quality above the minimum standard. Economists have long debated whether licensing or minimum quality standards serve to control entry, assure quality, or both (George J. Stigler 1971; Hayne E.
Leland 1979). In comparison, disclosure does not have a direct impact on entry, though the disclosed information may motivate consumers to shy away from low quality products and eventually drive out low-quality sellers.
Another way to look at table 1 is to identify the credibility and source of the quality assurance mechanism. Warranties and brands are offered and established by individual firms as a way to assure consumers of their own quality. Assuming they are enforceable, the effectiveness of warranties is self-explanatory. Brands have credibility because they are developed over time on the basis of experience and often require considerable expense to maintain.
Industries often assure quality of member firms, through disclosure, credentialing, or lobbying for licensing laws. Although these may serve as entry barriers, they may also limit the ability of member firms to free ride off of the industry’s overall positive reputation (David Dranove 1988).
Aside from disclosure by an industry group, certifying firms are usually independent of the individual firms they assess. The
JCAHO may certify hospitals, but individual members do not otherwise provide industry-

wide quality reports. An obvious explanation is the potential conflict of interest. One interesting exception occurs when financial analysts evaluate stock offerings in their own names, even though they are employed by investment banks involved in the offerings.
This practice could endure if the analyst’s own name is separable from the employer and the analyst develops a reputation of unbiasedness and accuracy.
To summarize, disclosure has three distinguishing features: First, disclosure systematically measures and disseminates information about product quality, which makes it attractive when other mechanisms for quality assurance are inadequate and the value of quality information when aggregated across all consumers is large relative to the costs of information collection.5 Second, disclosure is usually conducted via third-party certifier(s) that identify themselves separately from manufacturers. This may give consumers an impression that the disclosed information is more trustworthy than seller advertising.6 Third, disclosure standardizes quality assessment so that results are readily comparable across sellers. Instead of granting the power of licensing to government officials, disclosure empowers consumers with information with the expectation that consumer choice will provide sufficient incentives to assure quality.
Disclosure both complements and substitutes for other quality assurance mechanisms.
In lemons markets, disclosure provides more precise and comparable information than word of mouth, warranties and brand names.
Positive reviews may be especially helpful to companies that lack a strong brand. The

5 A glimpse at Consumer Reports and similar publications suggests that these factors are present in virtually all consumer goods markets where the goods are traded nationally or internationally, so that a single disclosure report can reach millions of potential consumers. Voluntary disclosure has traditionally been less common for local services where the costs of systematically collecting and disseminating information may be prohibitive relative to the size of the audience.
The Internet may be reducing these costs, however.

6 When producers self-disclose quantifiable quality information, consumers might infer that such information can be verified by third parties and is therefore trustworthy. Whether certifier-provided information is indeed more trustworthy than producer disclosure or consumer experience depends on certifier incentives, an active research topic we will review in details in sections
4 and 5.

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Journal of Economic Literature, Vol. XLVIII (Deccember 2010)

conventional wisdom is that strong reviews in Consumer Reports were critical to the s uccessful 1970s invasion by Japanese automakers into the American car market. By the same token, negative reviews can bring down established brands, as occurred after Ralph
Nader’s Unsafe at Any Speed chronicled problems with the Chevrolet Corvair. Firms in lemons markets may even band together and voluntarily disclose quality as a way to prevent an Akerlof-style adverse selection death spiral
(David M. Cutler and Richard J. Zeckhauser
1997). In the case of car safety, the 2000 mandated disclosure of rollover risks7 has fostered the set up of minimum performance standards for auto rollovers in 2005.8
1.2 A Brief History of Disclosure
Quality assurance has a long history. The term branding is derived from the practice of marking livestock that dates back as far as 2000 BC.9 Averill Paints secured the first U.S. trademark (an eagle) in 1870 while
Bass and Company (the brewer) and Lyle’s
Golden Syrup both claim to be Europe’s oldest brand, sometime in the late nineteenth century.10 Licensing in the United States can be traced to colonial days, when physicians had to obtain permission to practice from colonial governors.
Voluntary disclosure by industry participants emerged in the United States in the nineteenth century. The Chicago Board of Trade established a system for grading wheat (an example of voluntary disclosure) in 1848. In 1894, the National Board of Fire
7 Specified by the 2000 Transportation Recall Enhancement, Accountability, and Documentation Act.
8 Specified by the 2005 Safe, Accountable, Flexible,
Efficient Transportation Equity Act: A Legacy for Users.
9 This information was obtained from Daye, Derrick and VanAuken, Brad, 2006, “History of Branding.” http:// www.brandingstrategyinsider.com/2006/08/history_of_ bran.html. Searched 12/15/2008.
10 Source: Wikipedia. http://en.wikipedia.org/wiki/
Trademark#Oldest_trademarks and http://en.wikipedia. org/wiki/Brand#History. Underwriters established the Underwriters’
Electrical Bureau (the predecessor to
Underwriters Laboratories), which, in exchange for a fee, tested and reported on the safety of fittings and electrical devices.
This gave high quality sellers a way to distinguish themselves from inferior competitors.
According to Archon Fung, Mary Graham, and David Weil (2007), U.S. governmentmandated disclosure began with the 1906
Pure Food and Drug Act, which provided for inspection of meat products and monitoring of food and drug labeling. Since then, disclosure laws have spread to other markets. For example, the 1934 Securities and
Exchange Act requires public companies to file unaudited financial statements quarterly and audited financial statements annually, the 1968 Truth in Lending Act requires clear disclosure of key terms and all costs associated with a lending contract), and the 1986
Emergency Planning and Community Rightto-Know Act produces EPA’s Toxics Release
Inventory Report. Other examples include the 1990 Nutritional Labeling and Education
Act, and the hospital and doctor report cards adopted by New York and Pennsylvania in early 1990s.
The 1906 Pure Food and Drug Act was a response to Upton Sinclair’s The Jungle,
Samuel Hopkins Adams’s The Great
American Fraud, and other accounts of the meat packing and patent medicines industries. Horrific accounts of “Thalidomide babies” led to the 1962 FDA Amendments.11
Despite these high profile examples, James
Q. Wilson (1982) argues that mandatory disclosure laws are difficult to enact because the potential benefits are diffused among millions of individual consumers whereas the costs are concentrated among a few highly motivated sellers who can better capture
11 Thalidomide was a sleeping pill. Some pregnant women who used Thalidomide gave birth to infants with horrible deformities.

Dranove and Jin: Quality Disclosure and Certification the regulatory system. Graham (2002) gives three detailed examples of how public attention, industry lobbying, and political compromise shape mandatory disclosure laws.
Disclosure does not necessarily require legislation. Market driven, third-party disclosure first occurred in 1909 when John
Moody issued bond ratings, followed quickly by Poor’s Publishing in 1916 and
Standard Statistics in 1922.12 The first issue of Consumers’ Union Reports (the predecessor to Consumer Reports) appeared in
May 1936 and featured evaluations of milk, breakfast cereals, soap, and stockings. The
Internet has profoundly affected quality disclosure. Not only does the Internet facilitate the dissemination of quality information, it has spawned quality-rating features on websites such as cnet.com (consumer electronics), imdb.com (movie reviews), and tripadvisor.com (hotels). Rather than rely on experienced certifier(s) attesting to product quality, most of these websites aggregate the experiences of individual consumers.

941

disclose but not others? Why do some industries disclose but not others? Do sellers improve quality after a disclosure system is in place? Does disclosure drive out low quality sellers? • For regulators: Do we need mandatory disclosure, or will the market provide sufficient quality assurance through voluntary or third-party disclosure? • For third-party certifiers: What is the economics of certifiers? Do they have incentives to be truthful and thorough?
Does it matter if they collect revenue from sellers or buyers? How would competition, reputation, monitoring and the disclosure of conflicted interest affect certifier behavior?

• or consumers: How do consumers reF spond to disclosure? Does the response depend on the source of the quality information (mandatory versus voluntary versus third party)? Does the response differ by the contents and presentation of the disclosed information?

In the remainder of this essay, we review the theory and evidence on disclosure and certification. Most of the theoretical work focuses on the incentives for firms to voluntarily disclose quality and for certifiers to provide unbiased certification about product quality. Several empirical papers also address voluntary disclosure. Much of the empirical literature identifies challenges facing the practice of disclosure, ranging from measurement problems to unintended consequences and certifier bias. In the final section, we present some preliminary thoughts on the potential directions of future research. Our review is by no means exhaustive, nor do our examples cover all the industries that have adopted or attempted to adopt quality disclosure in practice. Even so, we cite scores of studies; for easy reference table 2 lists the citations by themes of insight.

• or sellers: How do sellers respond
F

to disclosure? Why do some sellers

2. Theory

12 The two companies merged in 1941, forming S&P, which was absorbed by McGraw–Hill in 1966.

The theory of quality disclosure can be divided into two strands. The first strand

1.3 Central Questions
The cursory history of disclosure raises numerous questions about the economics of disclosure. Since quality disclosure involves consumers, sellers, regulators and thirdparty certifiers, we organize the questions accordingly: 942

Journal of Economic Literature, Vol. XLVIII (Deccember 2010)

TABLE 2

List of Cited Papers by Themes of Insight
Themes

Citations

Theory: voluntary versus mandatory disclosure
Unraveling results
Grossman (1981); Milgrom (1981); Jovanovic (1982); Viscusi (1978)
Failure of unraveling:
Board (2009); Guo and Zhao (forthcoming); Jovanovic (1982); Levin, Peck, and Ye seller-side reasons
(2009); Matthews and Postlewaite (1985); Shavell (1994)
Failure of unraveling: buyer-side reasons

Fishman and Hagerty (2003); Hirshleifer, Lim, and Teoh (2004); Hotz and Xiao
(2009); Milgrom and Roberts (1986); Schwartz (2008); Stivers (2004)

Failure of unraveling: other reasons

Grubb (2007); Harbaugh, Maxwell, and Roussillon (2007); Gavazza and Lizzeri
(2007)

Consequence of mandatory disclosure

Bar-Isaac, Caruana, and Cuñat (2008); Jovanovic (1982); Gavazza and Lizzeri
(2007); Matthews and Postlewaite (1985)

Theory: the economics of certifiers
Quality measurement
Glazer et al. (2008); Miller, Resnick, and Zeckhauser (2005)
Certifier competition and
Albano and Lizzeri (2001); Faure-Grimaud, Peyrache, and Quesada (2009); information content of
Guerra (2001); Hvide and Heifetz (2001); Farhi, Lerner, and Tirole (2008); Lizzeri quality certificates
(1999); Miao (2009); SEC (2008); Skreta and Veldkamp (2009)
Reputation and other
Benabou and Laroque (1992); Bolton, Freixas, and Shapiro (2009); Cain, Loewen mechanisms that discipline stein, and Moore (2005); Durbin (2001); Mathis, McAndrews, and Rochet (2009); certifier behavior
Ottaviani and Sorensen (2006); Scharfstein and Stein (1990)
Practice on quality disclosure
Quality measurement
Dellarocus (2003); Iezzoni (1997); Kane and Staiger (2002)
Who volunteers to disclose?
Bushee and Leuz (2005); Edelman (2006); Francis, Khurana, and Periera (2005);
Jin (2005); Jin and Sorensen (2006); Leuz, Triantis, and Wang (2008); Lewis
(2009); Mathios (2000)
Consumer response to quality disclosure

Beaulieu (2002); Bundorf et al. (2009); Chernew, Gowrisankaran, and Scanlon
(2008); Dafny and Dranove (2008); DellaVigna and Pollet (2009); Dranove and
Sfekas (2008); Figlio and Lucas (2004); Greenstone, Oyer, and Vissing-Jorgensen
(2006); Hastings and Weinstein (2008); Ippolito and Mathios (1990); Jin and
Sorensen (2006); Marshall et al. (2000); Pope (2006); Romano and Zhou (2004);
Scanlon et al. (2002); Schneider and Epstein (1998); Xiao (2007); Wedig and
Tai-Seale (2002)

Seller response to quality disclosure

Bennear and Olmstead (2008); Carnoy and Loeb (2002); Chen (2008); Cullen and
Reback (2006); Deere and Strayer (2001); Dranove et al (2003); Figlio and Getzler
(2006); Haney (2000); Hanushek and Raymond (2004); Hanushek and Raymond
(2005); Jacob (2005); Jacob and Levitt (2003); Jin and Leslie (2003); Peterson and
West (2003); Powers et al. (2008); Lu (2009); Werner and Asch (2005)

Certifier bias, heterogeneity and competition

Beaver, Shakespeare, and Soliman (2006); Becker and Milbourn (2008); Berger,
Davies and Flannery (2000); Cantor, Packer, and Cole (1997); Cantor and Packer
(1997); Doherty, Kartasheva, and Phillips (2009); Feinstein (1989); Friedman
(1990); Hong and Kubik (2003); Hubbard (1998); Hubbard (2002); ); Jin, Kato, and List (forthcoming); Kliger and Sarig (2000); Lim (2001); Loffler (2005);
Macher, Mayo, and Nickerson (2008); Michaely and Womack (1999); Pike (2004);
Scanlon et al. (1998); Tan and Wang (2008); Thompson and Vaz (1990);
Waguespack and Sorenson (2010)

Political forces behind quality disclosure

Wilson (1982); Graham (2002); Fung, Graham, and Weil (2007)

Dranove and Jin: Quality Disclosure and Certification examines seller incentives to disclose quality information to uninformed buyers and often assumes that a third-party certifier can verify seller information. In this strand of literature, the main tension is between consumers who want more quality information to guide their choice of product and low-quality sellers who would like to hide in a pool of highquality sellers. In addition to redistributing the gains from trade between sellers and buyers, quality disclosure may also result in efficiency gains if better information leads to a better sorting between consumers and products, encourages sellers to improve quality, or forces low-quality sellers to exit the market. In contrast, the second strand of literature puts certifiers under scrutiny. It emphasizes that the interest of certifiers may not be aligned with that of buyers, and that certifiers can manipulate the information flow to the public. This introduces a number of complications because seller behavior is likely to change in response to certifier behavior and competition among certifiers could generate additional incentives for both sellers and certifiers.
Below we review the two strands of theory separately. In section 2.1, we summarize the existing theories on seller incentive to voluntarily disclose quality information and then address the merits of mandatory disclosure.
In section 2.2, we review theories regarding the role of third-party certifiers.
2.1 Seller Disclosure
The best known theory of quality disclosure is the so-called “unraveling result.”13
The term “unraveling” refers to the process whereby the best quality firm is first to disclose as a way to distinguish itself from lower quality firms. Once the best firm discloses, the second best firm has the same incentive
13 The term “unraveling” is first used in W. Kip Viscusi

(1978) who provides an example in the context of labor markets. 943

to disclose, and so forth until all but the worst firm discloses. According to Sanford J.
Grossman (1981) and Paul Milgrom (1981), if a seller possesses better information about product quality than consumers do and there is zero cost to verifiably disclose it, sellers will always disclose. This occurs because rational consumers will infer nondisclosure as having the lowest quality. It follows that sellers will voluntarily disclose quality unless consumers already have that information, implying that costly government-mandated disclosure is inefficient and nonnecessary.
In reality, there are many markets in which voluntary disclosure is incomplete. This is not surprising, because the basic unraveling result requires several often strong assumptions: • roducts are vertically differentiated
P
along a single, well-defined dimension of quality; • Sellers have complete and private infor mation about their own product quality; • isclosure is costless;
D
• onopoly or competitive market with
M
no strategic interaction among competing sellers; • onsumers are willing to pay a positive
C
amount for any enhancement of quality; • onsumers are homogeneous;
C
• onsumers hold a rational expectation
C
on the quality of nondisclosed products; • he distribution of available quality is
T
public information.
While any violation of these assumptions could lead to a failure of unraveling, theoretical research has focused on the problems

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Journal of Economic Literature, Vol. XLVIII (Deccember 2010)

posed by disclosure costs, market structure, and the role of consumers.
Grossman and Oliver D. Hart (1980) and
Boyan Jovanovic (1982) show that, when disclosure is costly, only sellers with product quality above a specific threshold will disclose. Casual observation suggests that hospitals that are highly ranked by healthgrades. com and other rating services often advertise their rankings, while “average” hospitals remain silent.14 Although Jovanovic focuses on a market with a large number of sellers, it is easy to extend the logic to monopoly as in Grossman (1981) and Milgrom (1981) because disclosure incentives are driven by skeptical consumers instead of competition among sellers. Steven Matthews and Andrew
Postlewaite (1985) and Steven Shavell (1994) show that, if it is costly to acquire quality information, mandatory disclosure may motivate sellers to reduce information collection. For example, a drug company might limit studies of side effects if required to disclose all findings from such studies.
Several theories link disclosure incentives to market structure. Oliver Board (2009) shows that under certain conditions duopolists may fail to disclose quality even if disclosure cost is zero. The main intuition is that disclosure may intensify price competition and this can outweigh any consumer perceptions of inferior quality. Liang Guo and Ying
Zhao (forthcoming) demonstrate that the amount of information disclosed depends on whether the duopolists disclose simultaneously or sequentially. As compared to simultaneous disclosure, the leader discloses unambiguously less information while the follower may reveal less or more information depending on disclosure cost. Dan Levin,
James Peck, and Lixin Ye (2009) show that,
14 Many consumers are unaware of hospital report cards although newspaper accounts of report card scores do seem to improve awareness. See Dranove and Andrew
Sfekas (2008) for further discussion.

when products differ in both vertical and horizontal dimensions, a monopoly cartel is more likely to disclose than duopoly because disclosure allows the cartel to raise the price to a greater extent for both sellers.
Unraveling requires consumers to play their part. Even if a third-party verification agency rates quality, sellers may hide their ratings if consumers are unaware of them
(Antoine Faure-Grimaud, Eloic Peyrache, and Lucia Quesada 2009). For example, restaurants have not usually disclosed their health and sanitation reports until compelled by regulation.15 By the same token, unraveling may not occur if consumers do not pay attention to the available information, if attentive consumers don’t understand the disclosed content, or if consumers make naïve inferences about nondisclosure (Michael J. Fishman and Kathleen M.
Hagerty 2003; David Hirshleifer, Seongyeon
Lim, and Siew Hong Teoh 2004; Alan
Schwartz 2008; Andrew E. Stivers 2004).
Under any of these conditions, lower quality sellers may not disclose because at least some consumers do not perceive nondisclosure as a signal of the lowest quality. This may further explain the lack of disclosure of hospital quality report card scores—patients may stubbornly believe that their health providers are above average even without disclosure.16 Unraveling may also fail if consumers have heterogeneous preferences for quality.
Board (2009) shows that, when duopolists fail to disclose quality, competition for heterogeneous consumers softens. V. Joseph
Hotz and Mo Xiao (forthcoming) highlight the importance of consumer heterogeneity when products differ in one vertical attribute
15 See Napa News, February 13, 2005, “Local restaurants skirt the law when it comes to telling diners about cleanliness and health.”
16 Dranove (2008) calls this the “Lake Woebegone effect,” named for humorist Garrison Keillor’s fictional town of Lake Woebegone, where “all of the children are above average.”

Dranove and Jin: Quality Disclosure and Certification
(quality) and one horizontal attribute (location). Under some configurations, providing consumers with more information may result in more elastic demand and more intensive price competition, which discourages both low and high quality firms from voluntarily disclosing their product quality.
Unraveling also assumes that consumers have perfect knowledge about the distribution of available quality. In some cases, disclosure can adversely shift the distribution of quality, thereby depressing consumer demand for the whole industry (Milgrom and John Roberts 1986). This explains why all cigarette manufacturers are reluctant to disclose the long-term harm of cigarettes, even if some cigarettes are less harmful than others. Other reasons for the failure of full disclosure include (1) the standard of certification is unclear or endogenous (Rick Harbaugh,
John W. Maxwell, and Beatrice Roussillon
2008), (2) a seller with high measured quality at a given point in time may fear the obligation to disclose in the future when measured quality might be lower (for example due to mean regression) (Michael D. Grubb 2007), and (3) high quality (and often nonprofit) sellers may face capacity constraints and/ or price regulations and therefore do not benefit from quality disclosure (Alessandro
Gavazza and Alessandro Lizzeri 2007). Some teaching hospitals have been reluctant to embrace report cards for the last reason.
Is it desirable to mandate seller disclosure? Market structure, unsophisticated consumers, and heterogeneous preferences may all precipitate against voluntary disclosure. Many of the papers cited above argue that, under these conditions, mandatory disclosure laws can promote competition and raise consumer surplus, often at the expense of firm profits. Indeed, the failure of disclosure, often revealed in public disasters, has fostered a number of government mandates.
But mandatory disclosure does not always

945

raise social welfare. When nondisclosure is due solely to disclosure costs, Jovanovic
(1982) shows that mandatory disclosure is socially excessive. Mandatory disclosure can also have unintended consequences, such as the aforementioned impact on seller effort in detecting quality (Matthews and Postlewaite
1985). Mandatory disclosure may encourage
“gaming” behavior that boost reported quality but actually reduce consumer welfare, as may be the case for hospital report cards that encourage providers to avoid the sickest patients (Dranove et al. 2003) or result in rationing of high quality outputs because high quality suppliers (for example schools and hospitals) face a binding capacity constraint (Gavazza and Lizzeri 2007). If there are multiple dimensions of product quality, mandatory disclosure on one dimension may encourage firms to invest in the disclosed dimension but cut back in other dimensions, leading to potential reduction in consumer welfare (Heski Bar-Isaac, Guillermo
Caruana, and Vicente Cuñat 2008).
2.2 Third-Party Disclosure and the
Economics of Certifiers
Third-party disclosure can eliminate the need for government mandated disclosure if the certifier can provide precise and unbiased information about product quality. However, that condition is hard to meet, sometimes due to the noise in the data generating process and sometimes due to conflict of interest. The theoretical literature has pinpointed how these problems inhibit third-party disclosure, with a particular emphasis given to market and nonmarket mechanisms that might limit certifier conflict of interest.
Quality ratings based on consumer feedback provide a prominent example of noisy data. Even if we limit attention to products that consumers can easily evaluate after consumption (think of Zagat’s rating of restaurant services and eBay’s rating of seller service), consumer ratings may be noisy or

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biased because: (1) different consumers may use different criteria to measure quality and these criteria are often implicit and unstable;
(2) those consumers who report quality may not represent all consumers (casual empiricism suggests that the most disgruntled consumers are overrepresented); (3) consumers may be reluctant to leave negative feedback in fear of retaliation in the future; and (4) consumer feedback is unverifiable, as consumers may offer feedback without ever having consumed the product and sellers may leave favorable reviews of their own products (while disparaging competitors).17
Researchers have offered solutions to problems inherent in consumer evaluations. Jacob Glazer et al. (2008) observe that reporting a simple average of consumer scores invites sellers to improve performance for the majority of consumers while ignoring product features that are costly to improve but only affect a small number of consumers.
For example, health plan report cards may encourage insurers to improve prevention services but spend little on improving cancer care. They propose assigning utility weights on different consumer respondents in order to correct this problem. Alternatively, Nolan
Miller, Resnick, and Zeckhauser (2005) propose rewarding individuals whose ratings predict peer ratings.
Recent events have put a spotlight on the potential conflict of interest in certifiers.
The Enron scandal raised questions about
17 Only half of eBay buyers leave feedback and very few

(