Communication and Courtship: Cheap Talk Economics and the Law of Contract Formation

Abstract:     
This paper provides an extended introduction to the game theoretic analysis of cheap talk -- actions which do not have a direct cost, but which affect equilibria only indirectly, via the information about sender type which they convey. After introducing these games, the article takes a functional approach to the law of contract formation as determining when talk is cheap (when an unfulfilled assurance will not trigger liability) versus when it is not (when an unfulfilled assurance that trade will take place triggers liability for the failure to trade). Using the neologism-proof equlibrium refinement due to Farrell, it is shown that when there is no liability, the unique stable equilibrium with pretrade cheap talk may be informative. Parties may communicate information even when talk is cheap because both parties have an interest in terminating costly negotiations if there is too low a probability that a deal will eventually be struck. There also exist situations in which cheap talk will be uninformative or "concealing," because one party is able to externalize a large share of the cost of negotiating to the other, and the other will not bear that cost if it knows that the probability of trade is actually quite low. The article discusses the general structural factors -- such as market thickness, bargaining power, and the similarity between sender and receiver types -- which determine whether there is a (stable) informative cheap talk equilibrium. It then points out that legal rules which attempt to fix liability based on a court's ex post perception of whether talk was concealing or informative ex ante are unlikely to improve matters. On this basis, it is argued that the default rule for letters of intent and other preliminary argreements should be that such agreements do not bind either party to trade. The very well developed law of the United States Court of Appeals for the Second Circuit on this topic is then explicated and critiqued. Other issues such as whether a communication is an offer or an offer solicitation and promissory estoppel in the preliminary dealings context are also explored. In particular, the analysis points out that while efficiency of the the classic Hoffman v. Red Owl is much more debatable than previously assumed, as actually applied by courts today, promissory estoppel in this context may be surprisingly efficient.

JEL Classifications: C70, K00

Accepted Paper Series