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Rev Fin 1999; 12:481-518
© 1999 the Society for Financial Studies

Article

Cheap talk, fraud, and adverse selection in financial markets: some experimental evidence

R Forsythe, R Lundholm and T Rietz
University of Iowa, USA
University of Michigan, USA
Corresponding author at: Department of Finance, College of Business Administration, University of Iowa, Iowa City, IA 52242, USA
e-mail: Thomas-Rietz@uiowa.edu

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.


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