The Failed Acquisition
A small tech startup has developed a revolutionary but unproven algorithm. A large corporation wants to acquire the startup. The startup's founders have internal data projecting massive future profits, but the acquiring corporation is skeptical and finds these projections difficult to verify. After months of costly 'due diligence' (the process of investigation and verification), the two sides remain far apart on a sale price and abandon the negotiation. Analyze this scenario to explain how an imbalance of information can act as a significant barrier to a mutually beneficial agreement.
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Economy
Introduction to Microeconomics Course
The Economy 2.0 Microeconomics @ CORE Econ
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Hypothetical Example: Information Asymmetry in Doctor-Confectioner Bargaining
Bargaining Breakdown
In which of the following scenarios is the primary barrier to reaching an efficient private agreement a transaction cost arising directly from information asymmetry?
The Strategic Barrier to Private Agreements
The Hidden Costs of Bargaining
In a negotiation over an externality, the effort and resources spent by one party to verify the other party's privately known damages is a form of transaction cost. Consequently, if this verification is successful and the true damages are revealed, this specific transaction cost is eliminated, and an efficient private agreement is guaranteed to be reached.
A chemical company is negotiating a private settlement with a downstream farm that would be affected by potential water pollution from a new plant. The farmer has a precise, private estimate of the crop yield losses they would suffer, but the chemical company does not have this information. Which of the following best describes a transaction cost stemming directly from this information imbalance?
A corporation is negotiating with a local community to compensate them for negative externalities from a new manufacturing plant. Match each specific challenge encountered during the negotiation with the type of transaction cost it best represents.
In a private negotiation over a negative externality, if the party causing the harm cannot easily determine the true cost of the damages incurred by the affected party, the affected party has a strategic incentive to __________ their claimed damages. This behavior and the effort to verify it represent a significant transaction cost.
The Failed Acquisition
Arrange the following events to illustrate the logical progression by which a private negotiation fails due to an imbalance of information between the parties.