Asymmetric information and fundamental uncertainty raise interesting issues in economics. Suppose that a natural gas company owns 10 plots of adjacent land and reports the “provable” quantity of natural gas that it can access at one of the plots. It is tempting to multiply this by 10 as optimists extrapolate that all of the plots are of equal quality. But, how do you know if the company is “cherry picking” and simply reporting the truth about its best plot (and hoping you will extrapolate) or is simply lying even about that plot? Do the executives of the firm have the right incentives to tell the truth? Their company’s stock price increases with announcements of “new proven reserves”. The NY Times is very concerned about this new case of winner’s curse. New accounting rules make it easier for gas companies to overstate their reserves and the NY Times is playing a useful role in spreading information about this point. Natural gas is the new thing as it offers domestic energy security and lower GHG emissions than fossil fuels. But, how much of this resource do we really have?
Nuanced investors know that they “do not know” how much gas these companies really can access and they do not know the future price of natural gas yet both are crucial in determining the price dynamics of shares of gas companies. Winner’s Curse arises when the most optimistic asset buyers purchase the stock because they overestimate the true reserves of gas that the company really owns (the average valuation is the best guess). For some technical discussion read Milgrom’s paper.
So, naive investors will lose money investing in these risky assets. What will nuanced investors do? Trusted geologists could be identified and they could conduct an independent investigation. If the public is skeptical about the claims the energy companies are making, then the stock prices will not rise with their own announcements of discoveries (because the information is not trusted). In this case, the natural gas companies who do indeed have parcels with natural gas would have an incentive to pay for independent verifiers to step in and conduct their own analysis to verify the truth. A separating equilibrium would take place as the truth would be revealed. Now, it is costly to reveal the truth (because the gas is trapped hundreds of feet down in the rocks) — then the outcome will still be a random variable but experts must have ways to elicit a “good guess”. The key here is that investors know “that they do not know” how much of a discovery has been made. Only, naive investors can be burned here but if the investors know they are naive why did they make the bet?