Second-Order Uncertainty in Accounting Information and Bilateral Bargaining Costs

Efficient contracting involves reducing the losses in wealth due to bargaining impasses, time and effort spent in negotiating, delays in implementing profitable projects, and second-best agreements. Properties of accounting systems play a significant role when bargainers haggle over accounting-based payoffs. This paper shows that bilateral bargaining requires more time and generates more reported subjective disutility when the accounting information used in contracting creates greater uncertainty about payoffs. We develop an argument linking accounting-based common uncertainty to the information asymmetry about bargainers' payoffs that drives bargaining costs. We also distinguish between two kinds of uncertainty: first-order uncertainty or simple risk (uncertainty about outcomes) and second-order uncertainty (uncertainty about probability distributions of outcomes). In an experimental setting, we show that the presence of second-order uncertainty increases bargaining costs, holding first-order uncertainty constant at a moderately high level. We also find that bargainers whose payoffs are affected by second-order uncertainty demand and receive a higher premium than bargainers whose payoffs are affected by simple risk only