Signaling

By Susanne Jutzeler,

2020-10-12 1
Talk is cheap
Actions speak
2
One of Darwin’s conundrums: A Peacock’s Feathers

“The sight of a feather

in a peacock’s tail,
whenever I gaze at it,
makes me sick.”

(C. Darwin, 1860)

Peacock’s Feathers

• One of Charles Darwin’s puzzles:

• Peacock has a long colorful tail

• Costly for the animal
• No obvious increase of the survival changes of the species

• “The sight of a feather in a peacock’s tail, whenever I gaze at it, makes me sick.” (C.
Darwin, 1860)

• How come that genetic selection did not remove this feature from the gene pool?

• Game Theory (And its sub-discipline Evolutionary Game Theory) might give an answer

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Peacock’s Feathers

• Possible answer: Signaling

• Feathers signal health of Peacock

• Peahen wans to mate with healthy Peacock as this increases likelihood for
healthy offspring

• This is an equilibrium
• Belief structure of Peahen is consistent with actions of Peacock
• Given behavior of Peahen: Peacock who wants to find a mate needs feathers

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Peacock’s Feathers

• Is signaling good or bad? Not obvious

• Informative: It might lead to more healthy fowl to be born

• Costly: But for a species as a whole this might be very costly

• BAD equilibrium might arise

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Signaling: the party example

• You are invited to Tom’s party. Should you bring a present?

[Answer: You need to check for a Bayes Nash Equilibrium]
• Tom has two types of friends: good friends and not-so-good friends [two types]
• Whether you are a good friend is not directly observed by Tom [type = not observed]
• Friends can bring one bottle of Tom’s favorite expensive drink (FED) or one bottle of
(diet) coke (which is observed by Tom) [signal = observed, costly]
• Because Tom has a nice house (with a pool) and is likely to throw more parties in the
future, not-so-good friends have an interest in being recognized as good friends
• You’re a good friend of Tom: you genuinely care about him. What should you do?
• A signaling equilibrium might arise in which only good friends bring an expensive
present, and not so good friends bring cheap present.

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Deadweight loss of Christmas

https://fs.blog/2013/12/the-economic-
https://www.amherst.edu/med
ia/view/104699/original/christ inefficiency-of-gift-giving-why-you-shouldnt-
mas.pdf buy-presents-for-the-holidays/

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Bit of irony

The author ‘s book became a

favorite Christmas present

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 Signaling: Part 2
Model Set-up

By Susanne Jutzeler

2020-10-12 10
Modeling Signaling

• When does signaling occur?

• Are signals always informative?

• Does signaling improve overall welfare?

• Does it occur in practice?

 Michael Spence
Nobel Laureate 2001

“Job market signaling” (QJE, 1973)

By Robert Scoble from Half Moon Bay, USA

https://commons.wikimedia.org/w/index.php?curid=3697162
Job market signaling: types

• Workers are of two types

• L-types with low productivity 𝒎𝑳 fraction 𝜌
• H-types with high productivity 𝒎𝑯 fraction 1 − 𝜌
• Average productivity 𝒎
ഥ = 𝜌𝑚𝐿 + 1 − 𝜌 𝑚𝐻
• Types are unobserved by the firms
• Firms are “color blind”
• Firms compete to attract workers

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Job market signaling: signal

• Workers choose the level of education 𝑒 ∈ {0, 𝐸} they acquire . [signal]

• Choose low level of education 0
• Or higher level of education 𝐸
• This is observed by firms [signal = observed]
• Education is costly to acquire [signal = costly]
• Education does not affect productivity m. [signal = not productive].
• Productivity = Productivity
<

• Productivity = Productivity

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Job market signaling: preference alignment

• Question: Can firms learn which workers are highly productive based on their
level of education?
• So : H-type chooses 𝑒 = 𝐸 and L-type 𝑒 = 0.
• Firm observes 𝑒 and knows which is of the H-type.
• Answer: Such equilibria might exist
• Requires an alignment of preferences
• What the firms care about (productivity) is associated with the cost of the signal (education).
• So education has to be less costly for the H-type.
• H-type might choose high level of education and receive a higher wage
• L-type might not be able to copy this, because education is too costly
• If preferences are not aligned: this type of learning will not occur
• If L-type has lower cost of education  Could signal L-type  but firms learn of low
productivity and provide low wage.

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Job market signaling: worker’s utility

• The utility 𝑈 of a worker i is

𝑈𝑖 = 𝑤 − 𝐶𝑖 (𝑒)
• The cost of education depends on type 𝐶𝒊

• Cost of no education is zero

𝐶𝐿 0 = 𝐶𝐻 0 = 0
• Marginal cost is higher for L-type (steeper curve)
𝐶𝐿′ 𝑒 > 𝐶𝐻′ 𝑒
• And differences in slope increases for higher levels of education
(curve bends more)
𝐶𝐿′′ 𝑒 > 𝐶𝐻′′ (𝑒)

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Job market signaling: worker’s utility
𝑈𝐿 = 𝑤 − 𝐶𝐿 𝑒 → 𝑤 = 𝑈𝐿 + 𝐶𝐿 (𝑒)

𝑤 = 4 + 𝐶𝐿 (𝑒) 𝑤 = 3 + 𝐶𝐿 (𝑒)
Wage (w) 𝑤 = 2 + 𝐶𝐿 (𝑒)
𝑤 = 1 + 𝐶𝐿 (𝑒)
𝑤 = 0 + 𝐶𝐿 (𝑒)

1
Education (e)
0
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 Job market signaling: worker’s utility

𝑈𝑖 = 𝑤 − 𝐶𝑖 (𝑒)
Wage (w) Utility of L-type
H-type has lower marginal cost
of education
 Flatter curves

H-type is less convex Utility of H-type

 function bend less upwards

Education (e)

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 Job market signaling: comparing utility

𝑈𝑖 = 𝑤 − 𝐶𝑖 (𝑒)
Wage (w) Utility of L-type

Take: Utility of H-type

wage w & Education E

High type will have higher

utility

𝑈𝐻 𝑤, 𝐸 > 𝑈𝐿 (𝑤, 𝐸)

Education (e)
E

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Job market signaling: setting wages

• Productivity m of workers is not observed

• Firms only observe education level e (= signal), so wage can only depend on
education 𝑤 𝑒
• Firms compete and make therefore zero profit
 In equilibrium workers are paid their marginal expected productivity 𝑚
• Firms use the information they have (education) to form expectations on the
productivity of workers, taking into account how they believe everyone is
behaving in the game
𝑤(𝑒) = 𝐸[𝑚|𝑒]

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Job market signaling: actions and equilibrium concept

• We now have all defined the set-up of the game to determine and are ready to
find the equilibrium actions

• We need to describe 4 actions:

1. Education strategy H-type worker 𝑒 = 0 or 𝐸
2. Education strategy L-type worker 𝑒 = 0 or 𝐸
3. Wage for worker with high education 𝑤(𝐸)
4. Wage for worker with low education 𝑤 0

• Those 4 actions need to form a perfect Bayesian Nash equilibrium

• Bayesian: because workers have two different types.
• Perfect: workers choose education first, then firms offer wages
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 Job market signaling: classifying actions

• We might have two types of equilibria:

• Pooling equilibria
• both types choose the same action (education level);
• Separating equilibria
• each type chooses a different action (education level);
Separating Reverse Separating Pooling on 0 Pooling on 𝐸
Actions by workers
H-type chooses 𝐸 0 0 𝐸
L-type chooses 0 𝐸 0 𝐸

• Games will typically have multiple equilibria

• History, Culture and beliefs might determine equilibrium..

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Job market signaling: Perfect Bayesian Nash Equilibrium

1. At any point in the game, we want (types of) workers to best-respond by

choosing the strategy that brings them the highest payoff
• Given 𝑤(0) and 𝑤(𝐸) both workers choose the right level of education

2. At any point in the game, given what firms know about the game and workers
strategies, we want firms to hold consistent beliefs, i.e. beliefs that do not
conflict with that information
• Beliefs 𝐸(𝑚|𝑒) should be consistent with the strategies taken by both types of workers

3. At any point in the game, we want firms to best-respond by choosing the

strategy that brings them the highest payoff
• Given their beliefs firms set wage 𝑤(𝑒) = 𝐸(𝑚|𝑒)

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Job market signaling: consistent beliefs

Firms hold beliefs that are consistent with the actions of the workers
Separating Reverse Separating Pooling on 0 Pooling on E

Actions by workers

H-type chooses 𝐸 0 0 𝐸
L-type chooses 0 𝐸 0 𝐸
Consistent beliefs by firms

can be anything
Belief for e = 𝐸 𝐸 𝑚 𝐸 = 𝑚𝐻 𝐸 𝑚 𝐸 = 𝑚𝐿 𝐸 𝑚𝐸 =𝑚
ഥ
in [𝑚𝐿 , 𝑚𝐻 ]
can be anything
Belief for e = 0 𝐸 𝑚 0 = 𝑚𝐿 𝐸 𝑚 0 = 𝑚𝐻 𝐸 𝑚0 =𝑚
ഥ
in [𝑚𝐿 , 𝑚𝐻 ]

Any belief is consistent with the actions of the workers

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End of this lecture

• In part 2:
• Introduced the questions of interest
• Introduced our model
• Classified our strategies
• Studied how the Perfect Bayesian Nash Equilibrium can be applied in this setting
• In part 3:
• Analyze the market equilibria
• Discuss the outcome
• Hopefully be able to answer some of our questions
 Signaling: Part 3
Model Analysis
Bert Willems

Picture By MattysFlicks

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End of this lecture

• In part 2:
• Introduced the questions of interest
• Introduced our model
• Classified our strategies
• Studied how the Perfect Bayesian Nash Equilibrium can be applied in this setting
• In part 3:
• Analyze the market equilibria
• Pooling – Separating equilibria
• Discuss the outcome
• Answer some of our questions
 Pooling on 𝐸

• Pooling on high level of education “E”

Utility of H-type Candidate equilibrium:
Wage (w) Utility of L-type H-type chooses E
L-type chooses E
Consistent beliefs:
𝑚𝐻 𝑒 = 𝐸 mixture of types  𝐸(𝑚|𝐸) = 𝑚 ഥ
𝑒 = 0 any belief 𝐸 𝑚 𝐸 ∈ [𝑚𝐿 , 𝑚𝐻 ]
is fine  let’s assume 𝑚𝐿
Best Response?
Choice of wages
𝑚
ഥ 𝑤(𝐸) = 𝑚
𝑤(0) = 𝑚𝐿
Wage offers
Choice of education
𝑚𝐿 E is optimal for H? Yes
H prefers (𝑒 = 𝐸, 𝑤 = 𝑚) to (𝑒 = 0, 𝑤 = 𝑚𝐿 )?
Education (e) E is optimal for L? Yes
L prefers (𝑒 = 𝐸, 𝑤 = 𝑚) to (𝑒 = 0, 𝑤 = 𝑚𝐿 )?
0 𝐸

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 Pooling on 𝐸: not always an equilibrium

• No pooling on high level of education “E”

Utility of L-type Candidate equilibrium:
Wage (w) H-type chooses E
Utility of H-type L-type chooses E

Productivity of Consistent beliefs:

type H (𝑚𝐻 ) 𝑒 = 𝐸 mixture of types
𝑒 = 0 anything between 𝑚𝐿 and 𝑚𝐻

Best Response?
Productivity of
Choice of wages
Population average (𝑚)
ഥ
𝑤(𝐸) = 𝑚
Wage offers 𝑤(0) = 𝑚 (let’s say)
𝐿
Productivity of
type L (𝑚𝐿 )
Choice of education
Education (e) E is optimal for H? Yes
𝐸 E is optimal for L? No

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 Pooling on 𝐸: not always an equilibrium

Utility of L-type
Wage (w)

Productivity of
type H (𝑚𝐻 )

Productivity of
Population average (𝑚)
ഥ

Productivity of
type L (𝑚𝐿 )

Education (e)
𝐸0 𝐸1
Range of 𝐸

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Pooling on 0: always an equilibrium

• There always exists a pooling equilibrium with 𝑒 = 0.

• Expected productivity for worker with education level 𝑒 = 0 is 𝐸 𝑚 0 = 𝑚
ഥ=
𝑤(0)
• Expected productivity for worker with education level 𝑒 = 𝐸 is not determined
by consistency argument.
So firms might hold low productivity belief: 𝐸 𝑚 𝐸 = 𝑚𝐿
• Education is costly and there is no reward for higher levels of education as
𝑤 0 =𝑚 ഥ and 𝑤(𝐸) = 𝑚𝐿
• Nobody invests in education

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Pooling equilibria : discussion

• Pooling on 0
• Nobody invests in education
• Firms do not learn the worker’s type.
• Workers are paid according to average productivity 𝑤 = 𝑚
ഥ
• Can be seen as a benchmark

• Pooling on E
• All workers invest in high level of education = Costly
• Firms do not learn the worker’s type
• Workers are paid corresponding to average productivity 𝑤 = 𝑚
ഥ
• Education and signaling is a pure waste for society

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 Separating equilibrium

• Assume Separating Equilibrium (i.e. sorting)

Candidate equilibrium:
Wage (w) Utility of H-type H-type chooses E
Utility of L-type L-type chooses 0

Productivity of Consistent beliefs:

type H (𝑚𝐻 ) 𝑒 = 𝐸 𝑚𝐻
𝑒 = 0 𝑚𝐿

Best Response?
Productivity of
Choice of wages
Population average (𝑚)
ഥ
Wage offers 𝑤(𝐸) = 𝑚𝐻
𝑤(0) = 𝑚𝐿
Productivity of
type L (𝑚𝐿 )
Choice of education
Education (e) 0 is optimal for L? Yes
𝐸 E is optimal for H? Yes
0

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 Separating equilibrium: not always an equilibrium

Wage (w) Utility of L-type • Cost of signal matters

If 𝐸 < 𝐸1
Utility of H-type Low type would choose 𝐸
• If E is too large: High type
If 𝐸 > 𝐸2
Productivity of prefers not to send the
High type would choose 0
type H (𝑚𝐻 ) signal

• If E is too small: Low type

Range of will mimic the signal, so
Productivity of
separating firms cannot afford to pay
Population average (𝑚)
ഥ
education high wage
levels
Productivity of
type L (𝑚𝐿 )
Education (e)
𝐸2 𝐸3

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Separating equilibrium: discussion

• High productivity workers invest in education

• Firms learn the worker’s type
• Workers receive a wage corresponding their productivity
𝑤 𝐸 = 𝑚𝐻 and 𝑤 0 = 𝑚𝐿
• Who gains compared to pooling on 𝑒 = 0?
• Firms make zero profit in both scenarios
• Low productivity worker : lower wage  looses
• High productivity worker: higher wage but invest in education  gains or looses
• Net effect for society : average wages remain the same, but education is wasteful.
• In a richer model: Signaling can provide useful information that could prevent
for instance markets from breaking down

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Reverse separating equilibrium: check yourself

• Does a reverse separating equilibrium exists?

• H-type chooses no education 𝑒 = 0
• L-type chooses high level of education: 𝑒 = 𝐸

• What are the consistent beliefs?

• What are corresponding wage?

• Is it optimal for workers to invest in education?

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Conclusion on signaling

• When can signaling occur?

• Separation: Alignment of preferences / Actions not to too costly or too cheap
• Pooling: Actions are cheap
• Are signals always informative?
• Only separating equilibria reveal information, but pooling equilibria do not
• Does signaling improve overall welfare?
• Pooling on 𝐸 all workers acquire unproductive education
• Separating equilibrium: average wage constant, but H-types acquire unproductive education.
Redeeming factor: Information might be used more effectively.
• Does it occur in practice?
• Predictive power somewhat limited (multiple equilibria)
• Refinements on equilibrium concepts (80-90s), but might not be so successful
• Let’s check for experiments / biology

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Signaling in the economic lab

• Signaling and separating equilibria are confirmed in the lab

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 Signaling in biology

• Ornament of Dung Beetle • Health and ornament size is correlated

Health
• Bi-modal distribution, corresponding to two
different strategies (more evidence of a
separating not a pooling equilibrium)
Clifton, S. M., Braun, R. I., & Abrams, D. M. (2016).
Handicap principle implies emergence of dimorphic
ornaments. Proceedings of the Royal Society B:
Biological Sciences, 283(1843), 20161970.

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So should you buy a bottle of Tom’s Favorite Expensive Drink?

• Assume: real friends are more willing to buy a drink for Tom than other friends
(they enjoy Tom having fun).
• What does our theory predict?
• There is always an equilibrium where nobody brings an alcoholic drink (𝑒 = 0)
• There might be equilibria where guests bring his FED, but this depends on how
expensive Tom’s taste is.

Dom Perignon Champagne Duché de Longueville

149.99 EUR 4.49 EUR

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 So should you buy a bottle of Tom’s Favorite Expensive Drink?

Cheap taste Very expensive taste

Who brings Tom’s FED? Everyone Nobody “Real” Friends Nobody
Pooling Eq. Separating. Eq

No extra invitation Invited to

to pool party pool party

• Analysis shows that there are different equilibria. Which equilibrium is played
often depends on social norms.
• Do you observe different habits in different circles of friends regarding
presents?
• Note that social norms depend on culture (e.g. Christmas gifts).
• China: ‘Hungbao’ wedding gifts are being recording and part of public record
book
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