For true wisdom,
transparency is the most powerful force,
and sincerity is the only path,
this is the essence of simplicity.
Nie Huihua · Professor, School of Economics, Renmin University of China
GeZhi LunDao Lecture 69 | June 19, 2021 Beijing
Hello everyone, I am Nie Huihua from the School of Economics at Renmin University of China. The title of my talk today is "Why Can't Deals Where Both Parties Make Money Be Done?" I hope to show you the power of information through this talk.
Reasons Behind Failed Deals
Let me start with a personal story that involves a question: "Why were there no direct flights between Boston and China?"
Boston is one of the largest cities in the United States and home to top world-class universities like Harvard and MIT. Every year, many students and scholars travel to Boston for tourism or study.
In 2009, when I went from Renmin University of China to Harvard University for my postdoctoral research, I had to fly from Beijing to Los Angeles, and then from Los Angeles to Boston.
I found it particularly strange at the time that the entire journey took over 20 hours, but Google Maps showed the direct aerial distance from Beijing to Boston was about 10,000 kilometers, and a direct flight would only take 12 hours, saving half the time.
Beijing is one of China's largest cities, and Boston is one of America's largest cities. There was so much passenger traffic between these two major cities, so why were there no direct flights? It wasn't until 2014 that Hainan Airlines opened a direct flight from Beijing to Boston. This shows that it was profitable. So why couldn't a deal that clearly benefited both sides be made?
Let me tell another story; these two stories might have a common underlying reason.
The second story is about Xerox's failed acquisition of HP. As you know, we now have a market economy, and the main players in a market economy are companies. For companies, one of the most important decisions is mergers and acquisitions, but 70% of M&As worldwide fail.
For example, the famous multinational company Xerox failed when it tried to acquire another famous multinational company, HP. In 2019, Xerox's first bid was 33.5 billion US dollars, which was rejected outright by HP. Xerox didn't give up and increased the price to 35 billion US dollars the following year, but it was still rejected by HP.
Theoretically, Xerox is the world's largest manufacturer of office equipment; many of the printers and copiers we use today are made by Xerox. HP is one of the world's largest IT companies; it was the world's largest computer manufacturer until two years ago when it was surpassed by China's Lenovo Group.
So Xerox acquiring HP should have been a win-win situation and a happy occasion for both strong companies. But why couldn't a deal where both sides could make money be done?
The chairman of HP's board provided an explanation. They believed, firstly, that Xerox's valuation of HP was too low; secondly, that Xerox was gaining too much advantage in the acquisition. Therefore, HP disagreed.
Although on the surface it seemed like a disagreement over price, the fundamental reason was information asymmetry. What is information asymmetry? This is the main point I want to discuss today.
Information asymmetry refers to a situation where one party possesses information that the other party does not, or one party has an information advantage, or private information. We often say, "The seller knows more than the buyer," which is a typical example of information asymmetry.
From "Symmetric Information" to "Symmetric Ignorance"
Completed: 30% //////////
Based on the distribution of information, we can discuss three situations:
The first situation is perfect information symmetry, which is the best case. For example, if Xerox knows that the profit after acquiring HP will be 40 billion US dollars, and HP also knows this, then it's symmetric information.
How much is HP itself worth? Let's assume it's worth 36 billion US dollars, HP knows this, and Xerox also knows this. In a situation where both parties have symmetric information, things are straightforward. One side is 36 billion US dollars, the other is 40 billion US dollars; taking a midpoint of 38 billion US dollars, the deal will surely go through, and both parties make the same amount of money, 2 billion each. So, information symmetry leads to very simple and efficient transactions.
This embodies the so-called Coase Theorem, which states that as long as property rights are clearly defined, information is symmetric, and transaction costs are low enough, the market will always reach efficient transactions. Simply put, there are no fools in the market; if everyone can make money, everyone will do it.
The deeper meaning it wants to convey is that because voluntary market transactions can always achieve multi-win or win-win outcomes, in most cases, government intervention is not needed, and the market can automatically achieve optimal resource allocation. This is a very important insight.
Coase won the Nobel Prize in Economic Sciences in 1991; the gentleman pictured below is him. He lived to be 103 years old, so a Chinese economist jokingly said that studying economics is the happiest thing; you can not only win the Nobel Prize but also live long.
▲Ronald Coase (1910-2013)
Although the Coase Theorem is powerful and useful, unfortunately, perfect information symmetry is rare; most of the time, we don't have such good luck.
The second situation is information asymmetry.
Information asymmetry is divided into two types: The first is unilateral information asymmetry, where one party possesses information that the other does not. The second is where each party possesses private information; for example, I know something you don't, and you know something I don't. This is called bilateral information asymmetry, which is the focus we need to pay attention to.
What happens in the case of bilateral information asymmetry? Economists Myerson and his collaborators at the University of Chicago found that in this situation, efficient transactions cannot be achieved, which is the so-called Inefficiency Theorem.
▲Roger Myerson
The Inefficiency Theorem was one of the main reasons Myerson won the Nobel Prize in Economic Sciences in 2007. This theorem sounds a bit counterintuitive. If one party having information the other doesn't easily leads to transaction failure, that's understandable. But why does having more information on both sides make a transaction impossible to achieve?
Let's take the example of Xerox's acquisition of HP again. Suppose Xerox and HP are now in a situation of bilateral information asymmetry. Xerox knows that the acquisition will bring in 40 billion US dollars in profit, but HP doesn't. Conversely, HP knows that its company's true value is 36 billion US dollars, but Xerox doesn't. This is called bilateral information asymmetry.
In such a game, they start negotiating. From an optimal strategy perspective, Xerox will significantly misrepresent or understate its acquisition profit. For instance, if it can make 40 billion, it will tell HP it can make at most 34 billion, so its bid cannot exceed 34 billion. Thus, its first bid is 33.5 billion.
Furthermore, it will definitely not raise its price or overstate its profit because once it overstates its profit or honestly says its profit is 40 billion, it will be in a passive position later, and raising the price would result in a loss. And from a game theory perspective, if your opponent says he can only make 40 billion, you wouldn't believe him even if he told the truth.
From HP's perspective, even though it knows its true value is 36 billion, it won't admit it. It will say its company has great prospects and thus demands 41 billion.
So, in this process, because of information asymmetry between the two parties, each party engages in strategic behavior, leading the seller's asking price to be far higher than the buyer's offer, resulting in a deal that could have been profitable for both sides failing to materialize.
What is the underlying reason? That is, under conditions of bilateral information asymmetry, each party wants to use the information asymmetry to increase their own profit and suppress the other party's profit. When the sum of the profits expected by both parties exceeds the total profit that can actually be allocated, efficient transactions cannot be reached.
Is there any way to break through information asymmetry? For example, would finding a third-party evaluation agency work? No. Because for such multinational corporations, while fixed assets, financial securities, etc., are easy to value, intangible assets like brand reputation are difficult to evaluate objectively and can only be assessed subjectively.
Moreover, the biggest challenge in acquisitions is the profit after the acquisition, which depends on the integration of the two parties' cultures, adjustments to the management team, and market conditions after the acquisition. These factors are all full of uncertainty, and no third-party evaluation company can accurately assess them.
What I just said might be a bit abstract, so let's take the money-splitting game as an example. Suppose you have 100 yuan to split with a classmate. Each of you secretly writes down the amount you want to get on a piece of paper, and then you reveal the numbers you wrote. If the sum is not more than 100, you get the amount you wrote down. But if the sum exceeds 100, you both get nothing.
Some people think this game is simple and believe that if both write 50, they achieve both fairness and efficiency. That's too idealistic.
Honestly, I've been teaching game theory for over ten years at the university, and every time I do this experiment in class, half the people end up getting nothing because no one wants to lose out.
Firstly, why should you get more money than me? If I concede and write 30, under equilibrium conditions, you should write 70. So why should you get 70, and I get 30?
Secondly, if I concede in this game, will I have to keep conceding in other games? So showing weakness might be a bad signal, and no one is willing to take a loss. This leads to everyone getting nothing.
Such a zero-sum game is very similar to a Prisoner's Dilemma. The Prisoner's Dilemma is one of the most famous terms in game theory, meaning that under conditions of information asymmetry, everyone tries to maximize their own interests, resulting in the minimization of collective interests.
The crucial point is that even if everyone knows such behavior might lead to the minimization of collective interests, there is nothing they can do to change this outcome, which is the tragedy.
Going back to the initial question, why were there no direct flights between Boston and China? Opinions on this might vary. The information I gathered is that it was due to bilateral information asymmetry regarding passenger flow between the two sides.
For example, one side might believe that passenger traffic is relatively stable and that airports should be expanded and flights increased; but the other side might not think so, believing that passenger traffic is not as much as imagined and is not as stable, thus disagreeing with increasing flights. China and the US each had their own calculations and information, leading to a situation where a potentially profitable deal could not be made.
For this, I specifically asked colleagues at the Civil Aviation Administration, and they said it was indeed because the two sides had different judgments about passenger traffic, which led to a failure to reach an agreement.
We just discussed two information situations: perfect information symmetry and information asymmetry. Now consider the third situation, where neither party possesses as much information, meaning both sides have less information. Does the situation get better or worse?
If the first situation of perfect information symmetry belongs to symmetric knowledge, then the second situation of bilateral information asymmetry is asymmetric knowledge, and the third situation is symmetric ignorance.
In the case of Xerox acquiring HP, suppose Xerox doesn't know its exact profit, only that its profit is between 38 billion and 42 billion US dollars, and HP knows this information. But HP doesn't know the true value of its company, only that its range is between 35 billion and 39 billion US dollars, and Xerox also knows this true information. So here, both parties know less information, but it is symmetric between them; it is symmetric ignorance.
In this situation, is the transaction more difficult to achieve? No, it's easier to achieve.
Because as long as either party proposes a price of 38 billion US dollars, the deal is easily made. 38 billion is the minimum profit line for Xerox; it's a sure profit, so it will agree. And HP will also agree because its average value is between 35 billion and 39 billion US dollars, so if the deal is made at 38 billion US dollars, it can still make an average of 1 billion US dollars.
In conclusion, in this situation of symmetric ignorance, both parties can always find a price that is profitable for both sides, thereby achieving an efficient transaction.
Symmetric Ignorance is a Form of Fairness
Completed: 70% ///////////
So, if we were to rank them, the best situation is undoubtedly symmetric knowledge, but this situation rarely occurs in reality. If the optimal is not achievable, the second-best is symmetric ignorance, meaning neither party knows more information, and the worst situation is asymmetric knowledge.
Simply put, in a transaction process, either both parties know all the key information, or both parties know nothing. The worst is when someone knows, and someone doesn't. This leads to an important conclusion: symmetric ignorance is better than asymmetric knowledge.
If we view information as a resource, it is like all other resources: people are not worried about scarcity but about unequal distribution.
In the era of big data, information has become one of the most important factors of production. People often focus too much on the inequality of material wealth and property distribution, while overlooking the inequality of information distribution. In fact, inequality in information distribution is sometimes more important; it can affect not only our transactions and lives but even people's basic rights.
John Rawls, the most famous political philosopher in the United States in the 20th century and a professor at Harvard University, wrote a very famous book, "A Theory of Justice," in which he introduced a very important term: the veil of ignorance. This means everyone has a large screen in front of them, and we cannot see the future; the future is unknown to us.
In Rawls' view, symmetric ignorance is a form of fairness. This is because decisions made by people behind the veil of ignorance truly align with the principles of justice.
To understand this, let me give an example. If you have a child taking the college entrance exam this year, would you agree to give bonus points to students with special talents?
Since this is a major decision, it requires everyone's opinion to reach a consensus, but I can assure you that everyone will absolutely not be able to reach a consensus. Because everyone has children, they know if their own child has artistic or athletic talents, but they don't know about other people's children. This is bilateral information asymmetry.
In this situation, if your child has artistic or athletic talents, you will firmly demand bonus points, the more the better. However, if your child does not have artistic or athletic talents, you will firmly oppose bonus points, making it impossible to reach a consensus. Therefore, knowing more information is not necessarily better.
But suppose the vote is not cast by parents, but by university students, or even high school students. They are likely to quickly reach a consensus, which is to give appropriate bonus points to students with special talents. Why? Because they don't know if their future children will have such talents.
If their child has talents, opposing bonus points now is equivalent to harming their own future interests. But if they agree to a significant increase in bonus points, and their future children don't have talents, it also harms their own interests. Therefore, the most conservative approach is to allow for appropriate bonus points.
Behind the veil of ignorance, because everyone doesn't know their future circumstances or luck, they might precisely take special care of those who are the least fortunate. In other words, under the veil of ignorance, people will strive to find a solution that protects the most vulnerable and least lucky people. This is known as the maximin principle.
We Need to Be Frank and Sincere
Completed: 80% //////////
Ray Dalio, the renowned American investment master and founder of Bridgewater Associates, the world's most profitable hedge fund, wrote a book called "Principles." In this book, Dalio revealed the most important secrets to success are radical truth and radical transparency. Only through radical truth and radical transparency can real information be disclosed, can the other party's needs be understood, and can a true consensus be reached, leading to a win-win outcome.
For true wisdom, transparency is the most powerful force, and sincerity is the only path. This is the essence of simplicity.
So, in reality, how can we return to a situation of information symmetry and make profitable transactions happen?
Let's look at a successful case. In 2010, the Chinese private enterprise Geely Automobile wanted to acquire Volvo, a subsidiary of Ford Motor Company, offering 1.8 billion US dollars. Ford asked if they could add a bit more because Volvo is also a valuable brand.
In response, Geely didn't hold back, but it also didn't say it was their final offer. Instead, it provided a large amount of data to prove that this was indeed the maximum profit it could generate and that bidding higher would result in a loss. So Ford was convinced. This was a successful acquisition. The 1.8 billion US dollars from 10 years ago is now worth 18 billion.
This example demonstrates once again that during negotiations, don't always think about taking advantage of information asymmetry to gain from the other party. That's a small deal. A truly big deal is one where both parties can make money; that's called having a broad perspective.
To conclude, I will summarize the main points:
First, bilateral information asymmetry can cause potentially profitable deals to fail because everyone wants to use the information asymmetry to increase their own profit and squeeze the other party's profit, resulting in the sum of expected profits exceeding the allocable profit.
Second, symmetric ignorance is better than asymmetric knowledge. More information is not always better, and less information is not always worse.
Third, when facing information asymmetry, to make valuable deals happen, we should be frank and sincere. As the saying goes, the greatest truth is simple, and only then can you persevere.
Finally, I want to remind everyone that we should not only focus on property fairness but also on information fairness, especially in the digital economy era, this is particularly important.
If you are interested in game theory and information science, you can also check out my new book, "Everything is a Contract," which discusses games and decisions in the real world.
Thank you all!
- END -
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