Imperfect Signals and Product Safety Disclosure: A Shepherd's Dilemma

Abstract

We study dynamic markets where product safety is unobserved by consumers. Perfect, but costly, audits and an exogenous noisy signal can provide information regarding seller type. Without the noisy signal, sellers do not disclose product safety without auditing. If audits are too expensive, a pooling equilibrium can result in consumption of unsafe goods. Even a noisy quality signal perfectly identifies unsafe goods by giving sellers incentives to disclose type without audits. Introducing a signal helps buyers, but its effect on sellers is ambiguous. Even if sellers benefit, they always suffer from increases in precision.

Keywords: adverse selection, product safety, noisy signals, credence goods, climate forecast, livestock disease

JEL Classification: D18, D82, L15, Q13