Cheap Talk is not Cheap: Free versus Costly Communication

The paper studies the effectiveness of communication in a two-player two-sided asymmetric information context. Both players choose simultaneously between two actions, with action L leading to a lower payoff for the co-player than action H. There are two types of players: D-types for whom L is dominant, and C-types for whom the optimal action is the same as the one chosen by the co-player, with both player choosing H providing the C-type a higher payoff than both players choosing L. Before the actions are chosen, each player can signal his/her intention to choose H. We consider three communication environments: No communication (NC), cheap talk (CT), and an environment with extrinsic communication costs (FC). According to standard theory the range of equilibrium payoffs of both types is the same in NC and CT, while for C-types the equilibrium payoff is highest in FC due to the Spence mechanism (Spence 1973). When we tested these predictions experimentally, the C-type payoffs were the highest in CT. In this environment the average observed C-type Payoff was even higher than the maximum equilibrium payoff. In CT about half of the D-types did not mimic the communication behavior of C-types, and hence even cheap talk revealed some information to the C-types. This indicates that half of the D-types were reluctant to make promises they would break. We introduce a theoretical model with promise-keepers. When the probability of an agent being promise-keeper is around 50%, the signaling rate will be higher in CT than in FC. On the other hand, for the same signal structure C-types choose more often H in the FC than in CT. These predictions are confirmed by the experimental results. Overall, the effect of the higher signalling rate in CT dominates: Together with presence of promise-keepers the higher signalling rate allows the C-types to coordinate more often on the « good » (H;H) outcome in CT, resulting in higher C-type payoffs in CT than in FC.