Signaling

Economics 302 - Microeconomic Theory II: Strategic Behavior

Instructor: Songzi Du
compiled by Shih En Lu
Simon Fraser University

March 23, 2015

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Most Important Things to Learn

Conditional probability (Bayes rule).

Understand the economic intuition of signaling.

Know how to find signaling equilibria.

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Quick Review of Probabilities

Let P(X ) be the probability of an event X occurring.

Let P(X , Y ) be the probability both events X and Y occurring.
Let P(X | Y ) be the probability of event X occurring given that event
Y has occurred.
Bayes rule:
P(X | Y ) =

P(X , Y )
.
P(Y )

Law of total probability:

P(X ) = P(Y )P(X | Y ) + P(not Y )P(X | not Y )

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Example 1

Your neighbor has 2 children. You learn that he has a son, Joe. What
is the probability that Joes sibling is a brother?

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Example 2

40% of population is rich, the other 60% poor. Among the rich, 40%
uses iPhone, and 60% uses Samsung Galaxy. Among the poor, 50%
uses iPhone, and 50% uses Samsung Galaxy. Suppose you see
someone uses iPhone, how likely is he/she rich?

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Example 3

Suppose a drug test is 99% sensitive and 99% specific. That is, the
test will produce 99% true positive results for drug users and 99%
true negative results for non-drug users. Suppose that 0.5% of people
are users of the drug. If a randomly selected individual tests positive,
what is the probability he or she is a user?

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Signaling

Sometimes, part of the informed side of a market wants to reveal

information.
Example: smart job applicants.
How to do so credibly?
Idea: certain tasks are easier for some people than others.
Example: going to school is easier for smarter (in an academic sense)
people.
If such tasks are worthwhile for some people, but not for others, they
can provide information about peoples type.

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Education as a Signal (Spence, 1973)

Two types of workers: skilled (s = 1) and unskilled (s = 0). Both are
risk-neutral.
Fraction p of the worker pool is skilled.
Education (e = 1 if educated, e = 0 if not) does NOT enhance skills.
It imposes cost c on skilled workers and k > c on unskilled ones.
So skilled workers have utility we ce and unskilled ones have utility
we ke, where w is the wage.

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Education as a Signal (Spence, 1973)

Two types of workers: skilled (s = 1) and unskilled (s = 0). Both are
risk-neutral.
Fraction p of the worker pool is skilled.
Education (e = 1 if educated, e = 0 if not) does NOT enhance skills.
It imposes cost c on skilled workers and k > c on unskilled ones.
So skilled workers have utility we ce and unskilled ones have utility
we ke, where w is the wage.
The firm observes education (e), but not type (s), pays workers their
expected skill level conditional on education:
w1 = E[s | e = 1] = (s = 1 | e = 1),
w0 = E[s | e = 0] = (s = 1 | e = 0).
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Equilibrium in a Signaling Game

Each type of the informed side (here skilled and unskilled workers)
must act optimally.
The uninformed side (the firm) has beliefs : probabilities on the
types of the informed side, conditional on the observables
(education) . It acts optimally based on those beliefs (i.e., pay wages
based on the conditional beliefs).

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Equilibrium in a Signaling Game

Each type of the informed side (here skilled and unskilled workers)
must act optimally.
The uninformed side (the firm) has beliefs : probabilities on the
types of the informed side, conditional on the observables
(education) . It acts optimally based on those beliefs (i.e., pay wages
based on the conditional beliefs).
Example: Educated workers are skilled with probability 0.7, and
non-educated workers are skilled with probability 0.2
(s = 1 | e = 1) = 0.7, (s = 1 | e = 0) = 0.2.

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Equilibrium in a Signaling Game

Each type of the informed side (here skilled and unskilled workers)
must act optimally.
The uninformed side (the firm) has beliefs : probabilities on the
types of the informed side, conditional on the observables
(education) . It acts optimally based on those beliefs (i.e., pay wages
based on the conditional beliefs).
Example: Educated workers are skilled with probability 0.7, and
non-educated workers are skilled with probability 0.2
(s = 1 | e = 1) = 0.7, (s = 1 | e = 0) = 0.2.
In equilibrium, beliefs must be consistent with what the informed
side is doing (derived from Bayes rule).
Example: If fraction q of the skilled and fraction q 0 of the unskilled
get educated, what must the firms beliefs be?

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Equilibrium in a Signaling Game

Each type of the informed side (here skilled and unskilled workers)
must act optimally.
The uninformed side (the firm) has beliefs : probabilities on the
types of the informed side, conditional on the observables
(education) . It acts optimally based on those beliefs (i.e., pay wages
based on the conditional beliefs).
Example: Educated workers are skilled with probability 0.7, and
non-educated workers are skilled with probability 0.2
(s = 1 | e = 1) = 0.7, (s = 1 | e = 0) = 0.2.
In equilibrium, beliefs must be consistent with what the informed
side is doing (derived from Bayes rule).
Example: If fraction q of the skilled and fraction q 0 of the unskilled
get educated, what must the firms beliefs be?
Note: beliefs after unexpected behaviour can be anything. So if
nobody gets educated, then the firm is free to have any belief if,
hypothetically, it sees an educated person.
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Pooling Equilibrium

Let w0 be the wage of uneducated workers, w1 be the wage of

educated workers.
In a pooling equilibrium, all types do the same thing.

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Pooling Equilibrium

Let w0 be the wage of uneducated workers, w1 be the wage of

educated workers.
In a pooling equilibrium, all types do the same thing.
For example, nobody gets educated, and everyone is paid w0 = p.

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Pooling Equilibrium

Let w0 be the wage of uneducated workers, w1 be the wage of

educated workers.
In a pooling equilibrium, all types do the same thing.
For example, nobody gets educated, and everyone is paid w0 = p.
If everyone gets educated, and everyone is paid w1 = p.

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Pooling Equilibrium I

Suppose no-one gets educated.

This is only sustainable if skilled workers dont find it worthwhile to
be educated. So we must have w1 c w0 = p.

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Pooling Equilibrium I

Suppose no-one gets educated.

This is only sustainable if skilled workers dont find it worthwhile to
be educated. So we must have w1 c w0 = p.
So any profile of the following form is a pooling equilibrium:
Nobody gets educated.
w0 = (s = 1 | e = 0) = p,
w1 = (s = 1 | e = 1) c + p

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Pooling Equilibrium II
Suppose everyone gets educated.
This is only sustainable if unskilled workers find it worthwhile to be
educated. So we must have w0 w1 k = p k.

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Pooling Equilibrium II
Suppose everyone gets educated.
This is only sustainable if unskilled workers find it worthwhile to be
educated. So we must have w0 w1 k = p k.
So any profile of the following form is a pooling equilibrium:
Everyone gets educated.
w1 = (s = 1 | e = 1) = p,
w0 = (s = 1 | e = 0) p k

This equilibrium exists only if k p.

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Separating Equilibrium

In a separating equilibrium, each type does something different.

Here, it must be that the skilled get educated, and the unskilled dont.

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Separating Equilibrium

In a separating equilibrium, each type does something different.

Here, it must be that the skilled get educated, and the unskilled dont.
w0 = (s = 1 | e = 0) = 0,
w1 = (s = 1 | e = 1) = 1.

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Separating Equilibrium

For the separating equilibrium to exist, it must be that:

1

the skilled find an education worthwhile: c 1; and

the unskilled dont find an education worthwhile: k 1.

Thus, the signaling device must be not too costly for some and costly
enough for others.

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Semi-Separating (or Partially Pooling) Equilibrium

In a semi-separating (also known as partially pooling) equilibrium, one
type plays a mixed strategy.
For example, fraction q of skilled workers get an education.

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Semi-Separating (or Partially Pooling) Equilibrium

In a semi-separating (also known as partially pooling) equilibrium, one
type plays a mixed strategy.
For example, fraction q of skilled workers get an education.
Thus, skilled workers must be indifferent between e = 1 and e = 0, so
w1 c = w0 .
Hence, unskilled workers will strictly prefer being uneducated, so
w1 = (s = 1 | e = 1) = 1.
Thus, w0 = 1 c. Also, we must have
w0 = (s = 1 | e = 0) =
Thus, 1 c =

p(1q)
1pq ,

so q =

p(1 q)
.
1 pq

p+c1
cp .

Since 0 < q < 1, this equilibrium exists if and only if 1 p < c < 1.
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Summary of Signaling Equilibrium

We always assume c < k and 0 p 1.

Equilibrium
Pooling (no education)
Semi-Separating (skilled mixes)
Pooling (education)
Semi-Separating (unskilled mixes)
Separating

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Parameter
no extra condition
1p <c <1
k p
p<k <1
c 1, k 1

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A Separating Equilibrium

Springbok stotting or pronking, signaling to predators that this is a fit

and fast animal, not worth chasing.
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A Pooling Equilibrium

Mexical Milk Snake (left, non-venomous) and Texas Coral Snake (right,
highly venomous)

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Signaling Summary

Credible mechanism for (potentially) revealing information.

Three categories of equilibria: pooling (no information is transmitted),
separating (type is always revealed) and semi-separating.
Whether (and how many) equilibria exist within each category
depends on model parameters.
Everywhere in life: gifts, how you dress, idiosyncratic application
requirements, etc.

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