Externalities and the Regulatory Role of Information Disclosure in Markets

Disclosure about most externality-related product attributes is not mandatory, and consumers have to rely on the information strategically disclosed by manufacturers. I study consumer perceptions in the voluntary disclosure model of Grossman (1981) and show that dirty manufacturers can mislead consumers about externalities by exploiting a phenomenon of wishful belief formation. The analysis is based on a novel approach to level-k thinking incorporating the psychology of belief formation. Bounded reasoning prevents consumers from deducing production processes from disclosure behavior. The resulting subjective uncertainty gives bite to wishful belief formation, which manufacturers can exploit through a strategic use of vagueness. These misperceptions reduce the pressure of the demand side on dirty production and unravel the clean market, with important implications for the role of mandatory disclosure to regulate externalities