Meet the Lemons: How Cheap Talk Overcomes Adverse Selection in a Decentralized Market Experiment

Abstract

We report an experiment on decentralized markets in which adverse selection is predicted to preclude trade of high quality goods. When allowing for costless and non-binding communication (cheap talk), there exists a partially separating equilibrium that results in a higher efficiency than the adverse selection benchmark. The partially separating equilibrium hinges on the presence of matching frictions, under which low quality sellers face a trade-off between successfully mimicking high quality sellers and an increased matching probability if they truthfully reveal their type. The experimental results follow the theoretical predictions of the partially separating equilibrium remarkably closely. Communication is informative and improves efficiency compared to the benchmark without cheap talk. We conduct control treatments to show that truth-telling is not explained by lie aversion or pro-social preferences, but is due to the pecuniary incentives of the partially separating equilibrium.