Inefficiency in the shadow of unobservable reservation payoffs

• Main Author: ANEY, Madhav S.
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2015
• Subjects: Economics; Economic Theory
• Online Access: https://ink.library.smu.edu.sg/soe_research/1870; https://ink.library.smu.edu.sg/context/soe_research/article/2870/viewcontent/Inefficiency_in_the_Shadow_of_Unobservable_Outside_Options_afv.pdf
• Institution: Singapore Management University

This paper considers the problem of allocating an object between two players in an environment with one sided asymmetric information when their reservation payoffs depend on the type of the informed player, causing the reservation payoff of the uninformed player to be unobservable to her. Inefficiency arises naturally in this setting and can be characterized by a simple condition on the reservation payoffs that is necessary and sufficient. I derive the necessary and sufficient condition for the existence of an implementable allocation that at least weakly dominates the reservation payoffs. Under a mild assumption on the distribution of types, I characterize the surplus maximizing mechanism in the second best setting. I argue that the model applies to an environment where property rights over the object are not well defined and are subject to costly enforcement. In such cases, type dependent reservation payoffs arise naturally as the uninformed player's expectation from the enforcement process. The model can explain why the best ways of avoiding costly dispute resolution, such as arbitration as a way of avoiding litigation, typically involve a degree of inefficiency.