Disclosure Rules in Contract Law

Abstract

How does the prospect of sale affect the seller’s incentive to investigate — to acquire socially valuable information about the asset? How do the disclosure rules of contract law influence the investigation decision? Shavell (1994) showed that, if sellers and buyers are symmetrically informed, at the pre-investigation stage, then a mandatory disclosure rule leads to a first-best outcome, and a voluntary disclosure rule leads to a suboptimal outcome. But in many real-world cases owners of assets have better information about their assets, even before they investigate. In such asymmetric information settings, we show, mandatory disclosure no longer attains a first-best outcome. And, under certain conditions, voluntary disclosure is the more efficient rule. We further enrich the analysis by introducing a third rule: the mandatory post-disclosure rule, which requires disclosure of material information, but only after the contract is concluded. We show that this rule can be more efficient than both voluntary disclosure and mandatory (pre-contract) disclosure.