Information, Incentives and Contracts: Lecture 2: Adverse Selection - How To Cope With It?

Information, Incentives and Contracts
Lecture 2: Adverse Selection - How to cope with it?
Dr. Renáta Kosová

How to cope with Adverse Selection?
I) Screening: The uninformed party (Principal) moves first to

retrieve information about the other party
II) Signaling: The informed party (Agent) moves first to convey

information about herself
© Imperial College Business School 2

I) Screening
• The uninformed party (Principal) moves first to retrieve

information about the other party
• If the agent tries to profit from information by keeping it

private, the principal will try to find a way to reduce her
informational disadvantage

Screening
Hiring
• What employers typically do to sort out high- vs. low-ability
employees (before hiring them)?
• However, there might be a problem of statistical discrimination:

– The employer may believe that an individual’s gender, race,
religion, or ethnicity is a proxy for ability.
– The ability distribution may be the same across high-skilled or low-
skilled workers but employers may deny being prejudiced
– This may keep skilled members of the discriminated group out of
suitable jobs.
 nowadays, employment laws and EDI initiatives try to prohibit or
eliminate this.

Screening
Retail
• Consider a market for detergent in retail stores. There are different
customer types: single, couples, family with children etc. The
characteristics of demand vary with the types. The seller does not
observe the types.
• Question: How can the seller vary the price and quantity sold to elicit
the hidden information from the customer in a profit-maximising way?
• Answer: Uninformed party, the seller, moves first and offers a menu
of quantities and prices. The informed party acts second and decides
to buy or not to buy (based on its demand-type)
 standard firm P-discrimination strategies you discussed in micro-econ

Screening
Financial Markets
Stiglitz and Weiss (1981): “Credit Rationing in Markets with Imperfect Information”
• Different borrowers have different probabilities of repaying the loan.
• The expected return to the bank depends on the probability of repayment.
2 effects:
1) For a given collateral, an increase in the rate of interest causes adverse selection - only
borrowers with riskier investments will apply for a loan at a higher interest rate.
2) Similarly, higher interest payments create an incentive for investors to choose projects with a
higher probability of bankruptcy.
• Banks want to identify ‘good borrowers’, hence, the interest rate acts as a screening
device.
– The interest an individual is willing to pay (those who are willing to pay high interest
rates, may, on average, be worse risks.)
II) Signaling
• There is asymmetric information
• However, after learning his type (and before signing the

contract), the agent can send a signal observed by the principal,
i.e., the informed party (Agent) moves first to convey
information about herself
– Before principal offers the contract, the agent takes some sort of
decision that may influence principal’s belief about the agent’s
identity
• Why?
– The best agents (usually the most efficient ones) get less utility if
their efficiency (type) is unknown to the principal

Order of Moves
Signaling
• N = Nature, A = Agent, and P = Principal
• Nature plays first choosing Agent’s type
• The agent holds private information before the
relationship has begun (unobserved by the Principal)
N chooses N
the type of A P designs A accepts A chooses Outcome
A sends a
which is only the (or supplies the state and
signal
observed by contract rejects) effort of the payoffs
A world

When is signaling viable?
• Carrying out some action where its cost decreases with agent’s
efficiency - previous to signing of the contract - can be a signal that
allows the principal to ascertain if the agent is efficient or not
• The signal’s cost should be sufficiently high

– Then the low efficiency agents won’t carry it out
• But also sufficiently low

– So that efficient agents will be willing to signal
• NOTE: The principal may still be interested in offering a different

contract than it would have been offered with complete/symmetric
information

Signaling
Lemon’s Market Example
• Consider the market for used cars. The quality of the cars
vary and is known to the owners, but not to the potential
buyers
• Question: How can an owner of a high quality car reveal

its type to the buyers?
• Answer: The informed party, i.e., the seller moves first

and sends a costly signal to the buyers

Signaling
Lemon’s Market Example
So, what type of signal this could be?
• Sellers of good cars would offer warranties (= insurance

to buyers)
• Such a signal should be affordable by the owner of a

good car but not by the owner of a lemon
Why?

Signaling
Other Examples
• Worker trying to reveal her/his personal characteristics to the principal designing
the contract
– Finishing the university (even if your degree is irrelevant to your job)
– Why?
• Firms/ co. directors signaling their characteristics to investors since it’s difficult for
investors to know the exact state of affairs of firms, quality of investments etc.
– Directors/ firms need to publicly disclose/publish financial statements, tax returns, etc.,
revealing their financial performance and the ‘debt-level accumulation’ as a signal
(information economics rationalises why financial structure of the firm matters)
• Product differentiation via prices or offering better warranties

– Consumers often perceive higher P as a signal of higher quality

Credibility
• Signals may or may not be credible. Why?

– individuals will use signals strategically when it suits them. Less
qualified applicants may ‘improve’ their resumes, lie about their
past work history/ qualifications…
• Talk is cheap…
• The more credible signals will involve more costly actions, e.g., a
college diploma, an artistic portfolio, a published book, a successful
business, a good company reputation…
Why? … Let’s demonstrate the logic via Full Disclosure example.

Full Disclosure Principle
ASSUME:
• There is a way (an inexpensive/costless one) to disclose credibly the
value/quality of product
• Sellers of good products have an incentive to disclose quality and they would be
able to disclose
• With asymmetric information, the sellers of bad products do not disclose the
quality of their products since the value of the product (e.g. painting) can only be
assessed ex-post
FINDING:
All sellers will choose to disclose if disclosure was credible & costless

Costless Verification
Painting Example
– Imagine a seller of a painting can get a free appraisal which will credibly
convey seller’s value of painting (using the example from Lecture 1)
– So, if E(Vs) = £50,000=Ps, hence Pb = £75,000 (Vb = 1.5Vs)? Would that

be true?
– This finding is incomplete. Since some owners disclose, it changes the
whole market, i.e., willingness to pay for non-appraised paintings
decreases
– If only sellers with Vs ≥ £75,000 disclose, what is the market price of non-
appraised paintings?
– But if the market price is £56,250, then sellers with Vs>£56,250 would
disclose, what is the market price of non-appraised paintings?

Costless Verification
Painting Example Cont’d
• We can continue with the same calculation and conclude that
all sellers will wish to have their paintings appraised.
• Why?
– Since each successive seller who has his painting appraised
devalues the paintings of those who do not. This in turn causes
additional sellers to wish to have their paintings appraised. In the
limit, the only seller with no incentive to obtain an appraisal is the
one with Vs = 0.
• Hence, we proved full disclosure principle.

– If disclosure is costless, in equilibrium all parties will explicitly or
implicitly disclose their private information.

What if Appraisal/
Verification is Costly?
Using the same painting example (see Appendix slides; optional) we can
show that:
• If verification of information is costly, the market equilibrium will exist

(unlike in pure adverse selection case (end of Lecture 1) when Pb=3/4P)
• But equilibrium is not Pareto Efficient due to two distortions:

– Sellers must pay for appraisal even though this investment does not
change the value of the painting/good (deadweight loss)
– Paintings with values lower than certain threshold will not be sold
even though they are worth 1.5Vs to buyers  that part of the market
will dissolve (similarly as we had in Lect. 1)

Perfect Bayesian Equilibria
Signaling Games
• In signaling games there is a ‘sender’ and a ‘receiver’
• The ‘sender’ has a type determined by nature
• The equilibrium concept relevant for signaling games is called ‘the Perfect
Bayesian equilibrium’
• These are the equilibria that arise in economic interactions in the presence of
incomplete information, where one side of the market has more information than
the other side
• Given beliefs, the Perfect Bayesian equilibrium is sequentially rational
• These equilibria can be divided in three different categories, pooling equilibria,

semi-pooling (also called semi-separating), and separating equilibria

Pooling Equilibrium
Signaling Games
• A pooling equilibrium is an equilibrium where senders with different types all
choose the same message.
– It’s an uninformative equilibrium.
• For example, a firm would like to hire the most productive individual, but
information about the individual's productivity is not directly observable.
• In such a scenario, the individual may attempt to signal his or her potential
productivity by means of some costly signal, such as the acquisition of education.
• However, if all individuals find it optimal to acquire the same level of education –
education makes no difference to firms - the equilibrium is called a pooling
equilibrium.
• As a result, the firms are unable to infer the productivity levels of the individuals
based on their decisions.
Separating Equilibria
Signaling Games
• A separating equilibrium is an equilibrium in which different
types of senders send different messages.
• If individuals with different underlying potential productivity

levels find it optimal to acquire different amounts of education,
their productivity types are revealed. This is called a separating
equilibrium.
• If there are more types of actors than there are messages, the
equilibrium can never be a separating equilibrium (but may be
semi-separating equilibria).

Semi-Pooling Equilibria
(Semi-Separating)
• Partially separating/pooling equilibrium is an equilibrium

in which some types of senders send the same message,
while some others send different messages.

Spence Model (1923)
Education as a signal
• College education could pay off because:
– It provides valuable training? or
– It serves as a signal to employers about worker’s ability
• Suppose education doesn’t provide training, it’s only a signal
• Hence, more able employees have a lower disutility (costs) from going
through education and therefore are more willing to educate themselves
than less-able employees
• Prospective employers understand this and therefore are willing to pay

educated workers more even if education per se does not add any value
for a specific job
Spence Model
Example
• Let’s assume we have 2 types of workers in society, with shares as follows:
– High ability workers are θ share
– Low ability workers are 1 – θ share
• Value of marginal product of workers

– wh: high ability worker
– wl (<wh): low ability worker
• Employer cannot directly determine a worker’s skill level
• So two types equilibria depending on whether the firm can distinguish high-ability
workers from others
– Pooling vs. separating equilibrium

Spence Model
Pooling Equilibrium
• If firms cannot distinguish high-ability workers from low-
ability workers, the outcome is a pooling equilibrium
– Dissimilar people are paid alike
– Employer pays all workers average wage:
– Risk-neutral, competitive firms expect to break even:

• Underpay high-ability workers
• Overpay low-ability workers

Education
Separating Equilibrium
• Suppose high-ability workers can get a degree at cost of c to
attend college
• Low-ability workers cannot graduate from college
• Thus, a degree is a signal of ability
• Outcome is separating equilibrium: one type of people take

actions (send signal) that allow them to be differentiated from
other type of people
– High-ability workers get wh
– Low-ability workers get wl

Education
When is separating equilibrium possible?
• High ability people have the choice whether they go to
college or not
• Going to college pays off if:

 wh – c > wl or What’s the intuition behind
 wh – wl > c these conditions?
• We can get a separating equilibrium if:

Example:
– c= £15,000; wh= £40,000; wl= £20,000 so
– wh – wl= £20,000 > c= £15,000
Education
When is pooling equilibrium possible?
• In a pooling equilibrium, all workers are paid an average wage
• If signaling is possible, high-ability workers:

– without a degree get average wage
– with a degree get wh
• So, they do not go to college if the benefit is less than cost:
• Hence, we can get pooling equilibrium
Example: using numbers from prior slide and assuming θ=50%, is

pooling equil. possible?

Education
Unique or Multiple Equilibria?
• Only pooling equil. is possible if schooling is too costly:
c > wh – wl
• If c = wh – wl , workers are indifferent btw. going to college
or not
• Only separating is possible if there are few high ability

workers:
θ < 1 – c/(wh – wl)
 See summary graph next slide…

Education
Pooling, Separating or Both?

Appendix
Demonstration of costly verification

implications, using painting example:
Optional

Costly Verification (1)
Painting Example Continued
• Imagine now that the seller of a painting must pay £5,000
for appraisal.
– Which paintings will be appraised?
– If there are non-appraised paintings, will they be sold and at
what price?
• We need to consider 3 factors:

1. The net price of a painting that the seller would obtain if
the painting were appraised (net of appraisal fee)
2. The net price if not appraised
3. The value of the painting to the seller (Sellers won’t sell
for a price less than Vs)

• 3 conditions to be met (Let A denote the action of Appraisal, A=1 means the
painting is appraised and A=0 means the painting is not appraised):
1. Buyer’s willingness to pay for an appraised painting is greater than or equal to seller’s
value of painting (Individual Rationality Constraint I):
Vb (A = 1) ≥ Vs + 5,000
2. Buyer’s willingness to pay for a non-appraised painting is greater than or equal to

seller’s value of painting (Individual Rationality Constraint II):
Vb (A = 0) ≥ Vs
3. Seller cannot do better by appraising a non-appraised painting or vice versa (Self-

Selection Constraint). Consider a cutoff value Vs*. In equilibrium, paintings with Vs ≥
Vs* are appraised and paintings with Vs < Vs* are not:
Vb (Vs ≥ Vs*, A=1) – 5,000 ≥ Vb (Vs ≥ Vs*, A=0)
Vb (Vs < Vs*, A=1) – 5,000 ≤ Vb (Vs < Vs*, A=0)

1. From Individual Rationality Constraint I, we have:
Vb (A = 1) ≥ Vs + 5,000
1.5Vs ≥ Vs + 5,000
Vs ≥ 10,000
• The owner of paintings with a value less than 10,000 would be making a loss if
they sold their painting after appraising it. That is, no painting under £10,000
would be appraised because the purchase price at the appraised value would not
compensate the seller for his reservation price.
• E.g. suppose the Vs = 6,000 and the seller appraises the painting by spending
£5,000. From our assumption we know that the buyer is willing to pay Vb = 1.5*Vs
= 1.5*6,000 = 9,000. Hence, we see that the seller makes a loss since:
Profit = 9,000 - (6,000 + 5,000) = - 2,000

2. From Individual Rationality Constraint II, we have:
Vb (A = 0) ≥ Vs (but could this be true?)
1.5E[Vs ≤ Vs*] ≥Vs,
Let’s solve for the case of equality
1.5E[Vs = Vs*] = Vs*,
3/4Vs*=Vs*
but this is only possible when Vs*=0
• We observe that, in the pure adverse selection case, non-appraised

paintings cannot be sold. There is no market for non-appraised
paintings since buyers are willing to pay less than seller’s valuation for
those non-appraised paintings.

3. Rewriting Self-Selection Constraint, to solve for the

critical value of Vs* :
Vb (Vs = Vs*, A=1) – 5,000 ≥ Vb (Vs = Vs*, A=0)

1.5Vs* – 5,000 ≥ (1.5Vs*)/2
(3/4)Vs* ≥ 5,000
Vs*≥ £6,666
Hence Vs* is at least equal to £6,666

Implications of Costly Verification
• Solving for all, we have:
– Vs*=10,000
– P (A=1) =1.5Vs (from above we know that this is the case when Vs ≥ 10,000)
– P (A=0) = 0
• That is, paintings with Vs ≥ 10,000 are appraised and sold at 1.5Vs but with a
minimum price of 15,000 (the lowest price that a seller of an appraised painting
with Vs = 10,000 would accept). Note that IR1 and SS implied different values of
the cutoff value of Vs* (10,000 and 6,666 respectively). Only IR1 is a binding
constraint because, if Vs* > 10,000, it is also the case that Vs* > 6,666
• Paintings that are not appraised are not sold since buyers wouldn’t pay more than
£7,500. But then, at that market price, buyers would not pay more than £5,625 and
so on…Hence, this portion of the market collapses (same logic as before)
• CONCLUSION: If verification of information is costly, the market equilibrium is not

Pareto Efficient due to two distortions
– Sellers must pay £5,000 for appraisal even though this investment does not change the
value of the painting (deadweight loss)
– Paintings with Vs < £10,000 are not sold, even though they are worth 1.5Vs to buyers

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Information, Incentives and Contracts

Lecture 2: Adverse Selection - How to cope with it?

Dr. Renáta Kosová

I) Screening: The uninformed party (Principal) moves first to

II) Signaling: The informed party (Agent) moves first to convey

© Imperial College Business School 2

• The uninformed party (Principal) moves first to retrieve

• If the agent tries to profit from information by keeping it

© Imperial College Business School 3

• However, there might be a problem of statistical discrimination:

© Imperial College Business School 4

© Imperial College Business School 5

• Different borrowers have different probabilities of repaying the loan.

• The expected return to the bank depends on the probability of repayment.

• There is asymmetric information

• However, after learning his type (and before signing the

© Imperial College Business School 7

© Imperial College Business School 8

• The signal’s cost should be sufficiently high

• But also sufficiently low

• NOTE: The principal may still be interested in offering a different

© Imperial College Business School 9

• Question: How can an owner of a high quality car reveal

• Answer: The informed party, i.e., the seller moves first

© Imperial College Business School 10

• Sellers of good cars would offer warranties (= insurance

• Such a signal should be affordable by the owner of a

© Imperial College Business School 11

• Product differentiation via prices or offering better warranties

© Imperial College Business School 12

• Signals may or may not be credible. Why?

Why? … Let’s demonstrate the logic via Full Disclosure example.

© Imperial College Business School 13

© Imperial College Business School 14

– So, if E(Vs) = £50,000=Ps, hence Pb = £75,000 (Vb = 1.5Vs)? Would that

© Imperial College Business School 15

• Hence, we proved full disclosure principle.

© Imperial College Business School 16

• If verification of information is costly, the market equilibrium will exist

• But equilibrium is not Pareto Efficient due to two distortions:

© Imperial College Business School 17

• The ‘sender’ has a type determined by nature

• Given beliefs, the Perfect Bayesian equilibrium is sequentially rational

• These equilibria can be divided in three different categories, pooling equilibria,

© Imperial College Business School 18

• If individuals with different underlying potential productivity

© Imperial College Business School 20

• Partially separating/pooling equilibrium is an equilibrium

© Imperial College Business School 21

• Suppose education doesn’t provide training, it’s only a signal

• Prospective employers understand this and therefore are willing to pay

• Value of marginal product of workers

• Employer cannot directly determine a worker’s skill level

© Imperial College Business School 23

– Employer pays all workers average wage:

– Risk-neutral, competitive firms expect to break even:

© Imperial College Business School 24

• Low-ability workers cannot graduate from college

• Thus, a degree is a signal of ability

• Outcome is separating equilibrium: one type of people take

© Imperial College Business School 25

• Going to college pays off if:

Vb (Vs = Vs, A=1) – 5,000 ≥ Vb (Vs = Vs, A=0)