Hidden Talents: Partnerships with Pareto-Improving Private Information

Can the presence of private information in a transaction yield a Pareto-improvement over complete information? In this paper we show that the combination of multi-agent simultaneous signaling of private information, and the nature of the strategic interaction, can result in non-cooperative equilibria which are Pareto superior to the complete-information non-cooperative equilibrium. Our application involves two agents who become partners in the production of a product (or the undertaking of a project). The partners� efforts are complementary and, in addition to its direct contribution to product quality, observable (but non-verifiable) effort serves as a signal for the unobservable component, talent; each partner is privately informed only about her own talent. Because the partners share the payoff from the project, each is tempted to shirk in providing effort. However, the need for each partner to signal the quality of the product to potential buyers serves as a credible commitment to provide greater effort. We find that this non-cooperative, simultaneous signaling need not be wasteful, and can actually be welfare-enhancing in the strongest sense: there is a portion of the parameter space wherein incomplete information is Pareto-improving relative to the complete-information non-cooperative outcome for all possible non-degenerate prior distributions over the private information. Therefore, the combination of simultaneous-move strategic interaction and incomplete information can lead to conditions wherein the �problem� of adverse selection actually mitigates the problem of moral hazard.