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Leonardo Felli

NAB.2.14

27 February 2014

Signalling Games

the following extensive form.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 2 / 39

Signalling Games: Example

(1, 3) r UL UR r (2, 1)

@

@ [p] L S1 R [q]

@..r r ..r

.. ..@

.. .. @

.. ... @r

r

(4, 0) DL ... .. DR (0, 0)

.. ( 12 ) ...

.. ..

.. ..

.. b N

.. R R ...

.. ..

.. ..

(2, 4) r UL .... ( 12 )

..

.. UR r (1, 0)

@ .. ..

@ ... ..

..r

@.r r

[1 − p] L S2 R [1 − q] @

@

(0, 1) r DL DR@r (1, 2)

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 3 / 39

Signalling Games: Equilibria

according to the beliefs of the receiver R at the information

set in which he is asked to play.

equilibria.

of sender S1 and S2 send the same signal (in this game a

choice of action aSi ) either L or R.

the equilibrium path.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 4 / 39

Signalling Games: Equilibria (cont’d)

I Bayes rule imposes that the beliefs at this information set are

the same as the probabilities with which nature takes its

choice ( 12 ) and ( 21 ).

types of sender S1 and S2 send the two different signals: L

and R.

equilibrium path.

I Bayes rule imposes that the beliefs at the two information sets

are degenerate: p ∈ {0, 1} and q ∈ {0, 1}.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 5 / 39

Pooling Equilibria

S1 and S2 choose strategy L.

7 1

ΠR (L, L; UL ) = , ΠR (L, L; DL ) =

2 2

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 6 / 39

Pooling Equilibria (cont’d)

(1, 3) r UL UR r (2, 1)

@

@ [p] L S1 R [q]

@..r r ..r

.. ..@

.. .. @

.. ... @r

r

(4, 0) DL ... .. DR (0, 0)

.. ( 12 ) ...

.. ..

.. ..

.. b N

.. R R ...

.. ..

.. ..

(2, 4) r UL .... ( 12 )

..

.. UR r (1, 0)

@ .. ..

@ ... ..

..r

@.r r

[1 − p] L S2 R [1 − q] @

@

(0, 1) r DL DR@r (1, 2)

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 7 / 39

Pooling Equilibria (cont’d)

that sustain this equilibrium.

not a best reply for S1 to choose L: he can gain by deviating

and choosing R instead.

both S1 and S2 to choose L.

Perfect Bayesian equilibrium we need R to choose DR at the

information set off the equilibrium path.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 8 / 39

Pooling Equilibria (cont’d)

ΠR (UR ) = q, ΠR (DR ) = 2 (1 − q)

2

q≤

3

1 2

(L, L); (UL , DR ), p = , q ≤

2 3

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 9 / 39

Pooling Equilibria (cont’d)

In other words given the following Bayesian signaling game:

(1, 3) r UL UR r (2, 1)

@

@ [p] L S1 R [q]

@..r r ..r

.. ..@

.. .. @

.. ..

(4, 0) r DL ... 1

.. DR@r

.. (0, 0)

.. (2) ..

.. ..

.. ..

.. b N

.. R R ...

.. ..

.. ..

(2, 4) r UL .... 1

(2)

..

... UR

r (1, 0)

@ .. ..

@ ... ..

@.r r .r

[1 − p] L S2 R [1 − q] @

@

(0, 1) r DL DR@r (1, 2)

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 10 / 39

Recipe:

I given these strategies, identify the receiver’s beliefs at every

information set that is on the equilibrium path;

I given these beliefs compute the receiver’s best reply at the

information set that are on the equilibrium path;

I verify that the sender’s equilibrium strategies you started from

are a best reply for the different types of sender;

I identify the restrictions that this last step imposes on the

receiver’s beliefs at information sets that are off the

equilibrium path (if there is any).

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 11 / 39

Pooling Equilibria (cont’d)

Equilibrium:

1 2

(L, L); (UL , DR ), p = , q ≤

2 3

and S2 choose the action R.

1

I Clearly Bayes rule implies that q = .

2

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 12 / 39

Pooling Equilibria (cont’d)

1

ΠR (R, R; UR ) = < ΠR (R, R; DR ) = 1

2

and choose L independently of whether R following L will

choose UL or DL .

I This implies that there there does not exist a Pooling Perfect

Bayesian Equilibrium where S1 and S2 both choose R.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 13 / 39

Pooling Equilibria (cont’d)

(1, 3) r UL UR r (2, 1)

@

@ [p] L S1 R [q]

@..r r ..r

.. ..@

.. .. @

.. ... @r

r

(4, 0) DL ... .. DR (0, 0)

.. ( 12 ) ...

.. ..

.. ..

.. b N

.. R R ...

.. ..

.. ..

(2, 4) r UL .... ( 12 )

..

.. UR r (1, 0)

@ .. ..

@ ... ..

..r

@.r r

[1 − p] L S2 R [1 − q] @

@

(0, 1) r DL DR@r (1, 2)

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 14 / 39

Separating Equilibria

L and S2 chooses R.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 15 / 39

Separating Equilibria (cont’d)

I Notice however that given R’s best reply S2 can gain a payoff

of 2 by deviating and choosing L instead of the payoff of 1 he

gets by choosing R.

Bayesian Equilibrium where S1 chooses L and S2 chooses R.

chooses R and S2 chooses L.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 16 / 39

Separating Equilibria (cont’d)

@

@ [p] L S1 R [q]

@..r r ..r

.. ..@

.. .. @

.. ... @r

r

(4, 0) DL ... .. DR (0, 0)

.. ( 12 ) ...

.. ..

.. ..

.. b N

.. R R ...

.. ..

.. ..

(2, 4) r UL .... ( 12 )

..

.. UR r (1, 0)

@ .. ..

@ ... ..

..r

@.r r

[1 − p] L S2 R [1 − q] @

@

(0, 1) r DL DR@r (1, 2)

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 17 / 39

Separating Equilibria (cont’d)

of 2 and can only earn a payoff of 1 by deviating.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 18 / 39

Separating Equilibria (cont’d)

and can only earn a payoff of 1 by deviating.

choose strategies R, respectively L.

(R, L); (UR , UL ), p = 0, q = 1

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 19 / 39

Spence Signaling Model

I There are two types of workers: high productivity workers θH

and low productivity workers θL

I A worker is of type θi wth probability πi

I Before entering the labor market workers may signal their type

by acquiring education.

I Different types of workers have different costs of acquiring

education.

I Employers can distinguish workers only by their education and

do not observe their ability.

I Employers compete in wages to hire workers given such

information.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 20 / 39

Timing

πi .

w (ei ) to each worker (they Bertrand compete for each

worker).

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 21 / 39

Educational Investment: Workers

I The cost of acquiring education e for type θi is

c(e|θi )

worker θL than for the high productivity worker θH :

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 22 / 39

Workers’ Preferences

I If the worker accept the wage offer w (e) then the payoff of a

worker of type θi with education e is:

preference guarantee that the single crossing condition is

satisfied.

the Spence-Mirrlees Single Crossing Condition are satisfied.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 23 / 39

Employers

worker of type θi is

worker is of type θi .

I Employers do observe the educational investment e of workers

I After workers have made their educational investments,

employers

I update their beliefs on the basis of this new observed

information e,

I offer a wage w (e) that depends on education.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 24 / 39

Types of Equilibria: Separating Equilibria

the two types of worker:

level selected by the other type.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 25 / 39

Types of Equilibria: Pooling Equilibria

two types of worker:

different educational level than the one selected by the other

type.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 26 / 39

Separating Equilibria: Characterization

i ∈ {H, L}

identify each type θi .

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 27 / 39

Separating Equilibria: Perfect Bayesian Equilibrium

imperfect information game.

I We solve the model backward ad start from theemployers’

Bertrand competition for each worker.

I Assume there exists two potential employers h ∈ {1, 2} for

each worker.

I Given two offers w1 (ei ) and w2 (ei ) the worker will choose the

offer (and hence the employer) such that

randomize with equal probability the offer to accept.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 28 / 39

Bertrand Competition

I Each employer h’s payoff is then:

f (θi ) − wh (ei )

if wh (ei ) ≥ w−h (ei )

1

Π(wh (ei )) =

2 [f (θi ) − wh (ei )] if wh (ei ) = w−h (ei )

0 if wh (ei ) < w−h (ei )

wh (ei ) = w−h (ei ) + ε if w−h (ei ) < f (θi )

wh (ei ) ≤ w−h (ei ) if w−h (ei ) = f (θi )

wh (ei ) < w−h (ei ) if w−h (ei ) > f (θi )

Competition subgame is then

wh (ei ) = w−h (ei ) = f (θi ), ∀i ∈ {H, L}

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 29 / 39

Employers’ Beliefs

each worker education investment ei , i ∈ {H, L}.

investment stage: θH workers choose eH and θL choose eL

where eH 6= eL .

employers compatible with a separating equilibrium are such

that:

Pr {θ = θi |ei } = 1

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 30 / 39

Educational Investment

I It must be a best reply for each worker of type θi to choose

the level of educations ei :

(incentive compatibility) conditions are:

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 31 / 39

Low Productivity and Education

has no effect on productivity.

on the part of θL workers is

eL∗ = 0

since

f (θL ) > f (θL ) − c(eL |θL )

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 32 / 39

High Productivity and Education

are such that

eH ∈ [e, e] eL = 0

with beliefs:

1 if e = eH

Pr {θ = θH |e} =

0 if e = eL

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 33 / 39

Off the Equilibrium Path Beliefs

1 if e ≥ eH

Pr {θ = θH |e} =

0 if e < eH

I Recall that Bayes rule does not impose any constraint on the

off-the-equilibrium-path beliefs.

f (θL ) if e < eH

w (e) =

f (θH ) if e ≥ eH

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 34 / 39

Off the Equilibrium Path

deviate:

f (θH ) − c(eH |θH ) ≥ f (θL ) − c(e|θH ) for all e < eH

f (θL ) ≥ f (θL ) − c(e|θL ) for all e < eH

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 35 / 39

Multiplicity of Equilibria

eH ∈ [e, e] & eL = 0

I But no equilibrium is efficient since θH workers waist resources

to signal their θH type by investing in education

I The Pareto dominant equilibrium is the one in which eH = e

since the cost of acquiring education is the lowest

I The multiplicity is due to the off-the-equilibrium-path beliefs.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 36 / 39

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