When market unraveling fails and mandatory disclosure backfires: Persuasion games with labeling and costly information acquisition

In this paper, we develop a variant of the persuasion game by Milgrom andRoberts to study the emergence and the desirability of product labeling whenbuyers can acquire information on the quality of the product by paying a cost.Labeling is modeled as the (verifiable) public disclosure of an otherwise un-observable trait of the seller that is correlated with the quality of the product.Our main finding is that market unraveling can fail, in which case imposingmandatory disclosure can backfire. When the joint distribution of seller'squalities and traits is exogenous, if market unraveling fails and mandatorylabeling is imposed, then profits decrease for high‐quality sellers and, if thelabel is sufficiently informative, buyers are better off and profits increase forlow‐quality sellers as well. When, instead, the joint distribution of qualitiesand traits is endogenous, mandatory labeling fails to yield an increasein average quality and buyers' utility, while cost inefficiencies arise