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

Abstract

We examine communication in two-player games that represent simplified financial markets with asymmetric information. In each game, a seller knows the true quality of an asset while the potential buyer knows only the ex ante quality distribution. First we document the degree of adverse selection in this setting by precluding any communication from the seller to the buyer. Then we examine how well two different communication regimes mitigate the adverse selection. In the "cheap talk"; treatment the seller can make any statement (even a fraudulent one) about the asset's quality to the buyer. The "anti-fraud" treatment imposes an anti-fraud rule where the seller's statement can be vague, but must include the asset's true quality. We find that both communication regimes significantly improve the efficiency of the market, but in very different ways. When sellers can cheap talk, buyers tend to over-rely on the sellers' often exaggerated claims and bid too much for the asset. The assets trade, but the efficiency gains come at the buyers' expense. This occurs even though subjects communicate anonymously, meet each other only once, and alternate between the role of buyer and seller in different subject pairings. Thus, the same subjects who are dishonest sellers are themselves gullible buyers. Adding the anti-fraud rule to the sellers' communications further improves efficiency and eliminates the wealth transfer from buyers to sellers.

JEL Classification: D82, G10, K22