How Verifiable Cheap-Talk Can Convey Unverifiable Information
45 Pages Posted: 28 Mar 2001
Date Written: February 2001
Abstract
This study describes a "cheap-talk" model in which sellers can credibly convey unverifiable information by choosing whether or not to exaggerate verifiable information. We find that unexaggerated claims can communicate favorable unverifiable information if buyers are not too likely to verify claims, and sellers with better information care more about future prices than sellers with worse information. However, there is always another equilibrium in which sellers exaggerate all verifiable claims. We use a laboratory experiment to test when each equilibrium arises. When buyers infrequently verify the sellers' claims, we find that the strategies used by players during the learning process determine which equilibrium is selected. When buyers are very likely to verify claims, players fail to converge to any equilibrium. Both of these results are consistent with an evolutionary learning model, but inconsistent with the intuitive criteria of Cho and Kreps (1987). We discuss the implications of our results for both consumer markets and financial markets.
Keywords: Earnings Management, Financial Reporting, Cheap Talk, Experimental Game Theory, Market Inefficiency
JEL Classification: M30, M41, M43, G14, D82
Suggested Citation: Suggested Citation
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