Cheap Talk, Fraud, and Adverse Selection in Financial Markets: Some Experimental Evidence

Abstract

We examine communication in laboratory games with asymmetric information. Sellers know true asset qualities. Potential buyers only know the quality distribution. Prohibiting communication, we document the degree of adverse selection. Then we examine two alternative communication mechanisms. Under “cheap talk”, each seller can announce any subset of qualities. Under “antifraud”, the subset must include the true quality. Both mechanisms improve market efficiency, but very differently. Relying on sellers' frequently exaggerated claims, buyers often overpay under cheap talk. Efficiency gains come at the buyer's expense. The antifraud rule improves efficiency further and eliminates the wealth transfer from buyers to sellers.