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Caveat Emptor: When Sellers Know More Than Buyers

Beware of bounded awareness in bargaining.

Key points

  • Sellers often know more about value than buyers.
  • Buyers tend to ignore the seller’s information advantage.
  • Careful research on market value can protect buyers from exploitation.

Sometimes one pays most for the things one gets for nothing. – Einstein

Sounds good. But where's the cave at? — Hoca Camide

When we buy a product or a service, we often do not have a clear idea of what it is worth. If we did, such knowledge would set our reservation price, defined as the largest amount of money we would be willing to spend. This reservation price represents true value, or rather, the value the good or service has to us. The positive difference between this reservation price and the price we end up paying is a measure of the happiness we extract from the transaction, which we can then add to the pleasure of having what we want.

It’s a dirty little secret that buyers often lack a clear notion of their reservation price. Their willingness to spend is elastic. Savvy sellers can work this uncertainty to their advantage. Some buyers find themselves at home with a new acquisition, wondering what happened.

In the marketplace, many sellers hold an informational advantage. They know more about what they are selling than buyers; they have a better fix on its true value, which means they can estimate the buyers’ reservation price more accurately than the buyers. This is especially so for sellers who do this all the time and buyers who only occasionally pop into the market. The pragmatic lesson for buyers is to do the hard work of market research before entering the fray of bargaining.

An efficient economic exchange leaves both parties better off. This can happen if the product or service – let’s call it p/s – is worth more to the buyer than the seller. There is a positive bargaining zone when the buyer’s reservation price is higher than the seller’s. This means that there is no single true value; this v is contingent on the agent – seller or buyer.

Consider this odd scenario: Suppose neither the seller nor buyer knows v. In this state of complete uncertainty, they pull a Laplace and assume that v may be any value from one and 100 with the same likelihood. P/S might be worth one or 13, or 91 monetary units, or any other value. They just don’t know.

Seller and buyer then infer an expected (i.e., average) value of 50 units. A risk-neutral seller would not ask for less than 50 because this would indicate a loss [though having 49 units for sure might be better than 50 for unsure]. For the same reason, a risk-neutral buyer would not offer more than 50 units. There is no positive bargaining zone and no deal.

What if, however, the buyer places 1.5 times as much value on the p/s than does the seller? Their respective reservation prices are now 75 and 50. Within this range, the two can haggle, with a split difference beckoning as a fair settlement. The buyer can offer 62.5, and the seller can accept it. Deal!

Samuelson and Bazerman (1985) introduced the Acquiring a Company Game (ACG) to show how attentional limitations can hurt the unwary buyer (see also Chugh & Bazerman, 2007). The ACG involves an asymmetry of information that is common in the world: The seller knows more about the p/s than the buyer does. The game consists of the situation described above, except that the seller knows v and the buyer does not. In this game, a player takes on the role of the buyer and is asked to make an offer. There is only one shot, and the seller, who might be played by a computer, another respondent, or Bazerman, accepts the offer if it is greater than v.

What many buyers fail to realize is that any accepted offer leaves them with a negative expected value. With an offer of X units, v can lie anywhere between one and X with equal probability. All values from X to 100 are now impossible because the seller would not agree to a loss. The expected value to the buyer is X/2 times 1.5, which is less than X. The buyer is now in the awkward position of having to rescind an offer already made. This violates transactional norms. The foresighted buyer should have realized ex-ante that any offer is pointless. In contrast, it is attractive for the seller to play this game because buyers can be counted on to overlook the implications of asymmetric information and to be averse to breaking the do-not-rescind-an-accepted-offer norm (Krueger, 2011).

What if the seller makes an offer first, leaving it to the buyer to accept or reject it? As v is hidden from the buyer’s view, the seller can float any offer of X > v and might as well propose X = 100. The buyer now faces a trust game (Evans & Krueger, 2016). Receiving an offer of X = 100 would be attractive if it were known that v is not much lower than 100. If this were so – but the buyer can’t know this to be true – a handsome profit would beckon. But if v is much lower, the seller wins big, and the buyer loses big. Conversely, if the seller makes a low offer, v must be even lower. Although the buyer might trust the seller more after a low offer because the seller apparently is not trying to score a very large profit, the game’s logic remains the same. The expected value stays negative.

When selecting an offer to present to the buyer, the seller must choose between seeking a larger maximum profit and seeking a higher probability of acceptance. The conflict between these two goals is acute for a low v. One almost feels bad for the seller. In theory, this unpleasant situation can be avoided if v is revealed to the buyer in a credible and unfakeable way. The two parties can then look forward, on average, to a fair exchange where each makes a profit of 12.5 units (see above) on average. Reality teaches, however, that sellers rather not reveal v. They seek to hide the extent of their profits.

Why is this so? Perhaps sellers believe that they can gain more from ill-informed buyers than from equal partners. And perhaps they are right. With v ranging from 1 to 100, the mean of the seller’s possible profits, X – v, ranges from two to 51.5. Each of these means can occur with a probability of .01, which amounts to a total expected profit of 26.75. This is more than twice as much as the full-disclosure split-the-difference profit of 12.5. A seller who expects a buyer to accept at least every other offer is better off hiding information about true value than revealing it.

Perhaps you recognize this situation from the last time you bought an object or service. That odd feeling in your stomach came from not knowing how badly you’d been had.

References

Chugh, D., & Bazerman, M. H. (2007). Bounded awareness: what you fail to see can hurt you. Mind & Society, 6, 1-18.

Evans, A. M., & Krueger, J. I. (2016). Bounded prospection in dilemmas of trust and reciprocity. Review of General Psychology, 20, 17-28.

Krueger, J. I. (2011, Dec. 3). What I learned from a Moroccan carpet merchant. Psychology Today Online. https://www.psychologytoday.com/us/blog/one-among-many/201112/what-i-le…

Samuelson, W. F., & Bazerman, M. H. (1985). Negotiating under the winner’s curse. In V. Smith (ed.), Research in Experimental Economics, 3, 105-137. JAI Press.

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