Adverse Selection, Signalling and Screening

Example: Mergers and acquisitions:

I An M&A businessman, Andy, is in negotiation with a
potential seller, Beth, of her firm, F.
I If Andy buys a firm with a current value $x, he can reorganise
and improve its market value to $1.5x and sell at that price.
I The current value of firm F, x, is drawn from a uniform
distribution on [0,$1m] and is private information of the seller.
I Naturally, Beth would sell the firm only if she can get a price
that exceeds x.
I If Beth accepts a price $p, Andy will infer that
I x < p and thus, all numbers in [0, p] is equally likely to be x;
I his resale price will be uniformly distributed on [0, 1.5p];
I Hence, his expected net profit is 0.75p − p < 0.
I That is, there is no price at which Andy is willing to buy.
Consequently, transaction will not take place whatever x is.
Adverse Selection, Signalling and Screening
Market failure due to Adverse Selection:
I Note that if x was known to Andy as well, a firm of any value
would have been traded and improved upon.
I Therefore, the above result of “no transaction at all” is a
market failure.
I The source of such market failure is asymmetric information:
if the information was complete (i.e., the buyers also have
access to the information) the firm would have been traded
for mutual benefit.
I Two devices that are observed in the market to overcome this
problem (at least partially) are signalling and screening.
An Economist article “Secrets and agents” at
http://www.economist.com/news/economics-brief/21702428-
george-akerlofs-1970-paper-market-lemons-foundation-stone-
information
Signalling

Stark examples of signaling:

I Drinking from a jar one has prepared is a definitive signal that
it is not poisoned (because the cost of doing so is much larger
for the one who poisoned the jar relative to the one who did
not, so much so that the former cannot afford to do so).
I In the underworld (of gangsters) where the info on the
member’s identity is of utmost importance, obtaining
membership requires a signal too costly for others (e.g.,
undercover policemen) to afford, e.g., committing murder.
Signalling
A preliminary model without education:
(1) The nature chooses a worker’s type/productivity t: t = H = 2
with prob λ ∈ (0, 1) and t = L = 1 with prob 1 − λ.
(2) Two firms, A and B, simultaneously make wage offers, wA
and wB , to the worker.
(3) The worker decides whether to accept wA and work for firm
A, to accept wB and work for B, or to reject both offers and
take an outside option.
(4) If the worker works for firm i = A, B, then the worker’s payoff
is wi , firm i’s payoff is t − wi where t is the worker’s type,
and the other firm’s payoff is 0. If the worker takes an outside
option, he receives his outside option value rt and both firms’
payoffs are 0, where the worker’s outside option value (also
known as “reservation utility/payoff”) is rL < 1 for L-type,
and is rH > 1 for H-type.
Signalling

We assume that rH < 2 so that it is socially beneficial for H-type

worker to participate in the labour market. In particular, we
assume that
1 < rH < 1.5.
Observe that firms
I attract no worker by offering wi < rL ;
I attract only L-worker by offering wi ∈ [rL , rH ), in which case
the expected productivity of a hired worker is 1;
I attract both types by offering wi ≥ rH , in which case the
expected productivity of a hired worker is 2λ + 1 − λ = 1 + λ;
I and should offer at least the expected productivity of a hired
worker due to competition but no more to not make a loss
and thus, they offer exactly the expected productivity of a
hired worker.
Signalling
• If 1 + λ < rH , therefore, it is not possible both types are hired
because that would require firms offering more than rH but they
would make a loss by doing so. Thus, only L-type workers may be
hired in any equilibrium, resulting in market failure due to
incomplete information. Specifically, the following is a PBE:
I Both firms offer the same wage equal to the productivity of
L-type (wA = wB = 1); and an L-type worker accepts either
firm’s offer with equal probability and an H-type worker takes
the outside option. The equilibrium payoff is 1 for an L-type
worker, rH for an H-type worker, and 0 for both firms.
• If 1 + λ ≥ rH , on the other hand, the firms can attract both
types of worker by offering their expected productivity (wi = 1 + λ)
as it exceeds the outside option values for both types. In
equilibrium this will actually happen and market failure is avoided.
• We will examine how signalling works and may alleviate market
failure in the former case.
Signalling - Spence
Education signalling - Model:
(1) The nature chooses a worker’s type/productivity t: t = H = 2
with prob λ ∈ (0, 1/2) and t = L = 1 with prob 1 − λ.
(2) Conditional on his type,(the worker chooses an education level
c(e, H) = e/2 if H-type
e ≥ 0 which costs him
c(e, L) = e if L-type.
(3) Observing the chosen education level e, two firms, A and B,
simultaneously make wage offers, wA (e) and wB (e)
(4) The worker decides whether to take wA (e), wB (e), or an
outside option.
(5) If the worker works for firm i = A, B, then
I his payoff is wi (e) − c(e, t) depending on his type t;
I firm i’s payoff is t − wi (e), and the other firm’s payoff is 0.
If the worker takes an outside option, his payoff is rt − c(e, t)
and both firms’ payoffs are 0.
I Note that the education does not enhance productivity–This
is for simplicity but it also makes the signaling function of
education more transparent.
Signalling - Spence

A strategy profile specifies

(i) an education level for each type of the worker, eH and eL ;
(ii) a wage schedule wi (e) for each firm i = A, B, that specifies a
wage offer depending on all possible education level e ≥ 0
that the worker might take;
(iii) for each possible pair of wage offers (conditional on the
education level taken), the worker’s choice among the two
firms’ offers and an outside option.
I For (iii), it is obvious that he would take the higher offer so
long as it is no worse than his outside option;
I in case the two offers are the same (and no worse than his
outside option), we postulate that he accepts either with equal
probabilities.
Signalling - Spence

Lemma 3.1: Consider the stage in which a certain education level

e is observed and the posterior belief at this information set
assigns a prob µ(e) to the worker being of a H-type. Given this
belief, the NE of the “continuation game” from this information
set onwards is as follows.
(a) If 1 + µ(e) < rH , both firms offer wA (e) = wB (e) = 1 and an
L-type worker accepts either with equal probabilities while an
H-type worker takes the outside option.
(b) If 1 + µ(e) ≥ rH , both firms offer wA (e) = wB (e) = 1 + µ(e)
and both types of worker accept either firm’s offer with equal
probabilities.
Signalling - Spence
Separating PBE: eH∗ 6= eL∗ .
I Since µ(eL∗ ) = 0 by Bayes’ rule, wA (eL∗ ) = wB (eL∗ ) = 1.
I However, since wi (e) ≥ 1 for all e ≥ 0 by Lemma 3.1, it is
optimal for L-type worker to choose eL∗ only if eL∗ = 0. Thus,
eL∗ = 0.
I Since µ(eH∗ ) = 1 by Bayes’ rule, wA (eH∗ ) = wB (eH∗ ) = 2 and
the worker accepts either with equal probability by Lemma 3.1
(b).
I For the two types’ e choices to be optimal, the following
Incentive
( Compatibility (IC) conditions are necessary:
wi (eH ) − eH∗ /2 ≥ wi (eL∗ ) − eL∗ /2 for H-type
∗

wi (eL∗ ) − eL∗ ≥ wi (eH∗ ) − eH∗ for L-type.

∗ ∗ ∗
Given eL = 0, wi (eL ) = 1 and wi (eH ) = 2, these IC conditions
determine 1 ≤ eH∗ ≤ 2.
Signalling - Spence
Separating PBE: eH∗ 6= eL∗ (cont’d)
I Also
( necessary are the following Participation Constraint (PC):
wi (eH∗ ) − eH∗ /2 ≥ rH (the outside option value) for H-type
wi (eL∗ ) − eL∗ ≥ rL for L-type.
These are satisfied if eH∗ ≤ 4 − 2rH . Note that 4 − 2rH > 1 as
rH < 1.5.
I Summarizing, there is a continuum of separating equilibria
that vary in eH∗ : eL∗ = 0, 1 ≤ eH∗ ≤ 4 − 2rH ,
wA (eL∗ ) = wB (eL∗ ) = 1 and wA (eH∗ ) = wB (eH∗ ) = 2.
I To complete the description of the equilibrium, we need to
take care of “off-equilibrium” paths by specifying strategies
and a “legitimate” belief profile for contingencies that does
not arise according to the equilibrium strategies, in particular,
after e 6= eL∗ , eH∗ :
I wi (e) = 1 and µ(e) = 0 for 0 < e < eH∗ , and
I wi (e) = 2 and µ(e) = 1 for e ≥ eH∗ .
I Illustrate these with diagram.
Signalling - Spence
Separating PBE: eH∗ 6= eL∗ (cont’d)

               w         uL = w − e = 1  

                                 H             uH = w − e /2 = rH    

                 2       €                                                        

                €      

                   
                rH                    

               1                                                    

€        L      

  0                                  1             4 − 2rH                e  
Signalling - Spence
Separating PBE: eH∗ 6= eL∗ (cont’d)

               w         uL = w − e = 1  

                                 H          

                 2       €                                                        

                    wi (e) = 2   supported  by   µ (e) = 1.  

                   
                rH             €         €
               1                                                    

€        L           wi (e) = 1    supported  by   µ (e) = 0.  

  € €
  0                                                               e    
*
H            e  
Signalling - Spence
Equilibrium refinement using the Intuitive Criterion
I Suppose a separating equilibrium with e ∗ > 1, and notice
H
i) that a L-type worker would never do better than following the
equilibrium by choosing some e ∈ (1, eH∗ ) instead, because no
firm would ever offer more than 2 in any circumstances,
ii) whereas a H-type worker could possibly do better than the
equilibrium by choosing e ∈ (1, eH∗ ) in case the subsequent
wage offer is (sufficiently close to) 2.
I Hence, it would be sensible for the firms to think that the
worker would be of H-type in case they see such e ∈ (1, eH∗ )
chosen unexpectedly, hence make a wage offer of 2.
I Foreseeing this, a H-type worker would indeed choose such e,
thereby upsetting the supposed equilibrium.
I Consequently, the separating PBE with eH∗ = 1 is the only one
that survives this refinement criterion, introduced by Cho and
Kreps (1987) and called the Intuitive Criterion.
Signalling - Spence

Pareto improvement by signaling? Comparing the separating

PBE’s with the equilibrium without signaling opportunity, we get
the following implications:
I If market failure were to prevail (i.e, 1 + λ < rH ), signalling
alleviates market failure as H-type also participates in the
market and brings about Pareto-improvement: H-type worker
is better off with signalling than without (2 − eH∗ /2 ≥ rH )
while L-type worker and firms are equally off with and without.
I However, relative to the case of complete information, market
participation of H-type comes with a signalling cost which is
borne by an H-type worker.
I If market failure doesn’t arise (i.e, 1 + λ ≥ rH ), however,
signalling benefits H-type worker at the expense of L-type
worker.
EXERCISE

Consider the model used in lecture for education signalling modified as

below: The worker’s productivity increases with education so that it is
2 + (e/4) for a high type worker with education e and is 1 + (e/4) for a
low type worker with education e. The reservation utility levels of types
H = 2 and L = 1 are 1.2 and 0.6, respectively. (As before, the worker’s
cost of obtaining e is e/2 for high type while it is e for low type.)
(a) Describe the equilibrium when the worker’s type is publicly known.
Answer the following questions assuming that the worker’s type, which is
high with probability λ ∈ (0, 1/2), is private information.
(b) Describe the equilibrium when education opportunity does not exist.
When does market failure results?
(c) Suppose now that the education opportunity is present. Determine
whether it may constitute a separating equilibrium for the worker to take
an education level of 2 if he is of a high type and 0 if he is of a low type.
(d) Discuss who benefits from signaling. Relative to the case of no
asymmetric information, who bears the signaling cost?