(8) Adverse Selection and Signaling

Question 1

Principal-Agent Models - Definition

Answer 1

• Principle hires the agent to perform a task

- The principles designs a contract to govern the relationship between himself and the agent

Question 2

What are the problems regarding principal agent models?

Answer 2

• The interaction has the potential to create surplus (win-win) but the principal has incomplete information
• Hidden Information: Principal may not know the agents ‘s characteristics (his abilities)
• Hidden Action: Principal may not know what the agent is doing (his work effort)
• Result: There is a conflict of interest

Question 3

Pooling EQ - Definition

Answer 3

Informed Player sends the same signal irrespective of Nature’s move.

Question 4

Separating EQ - Definition

Answer 4

Informed Player sends different signals depending on Nature’s move.

Question 5

Hybrid EQ - Defintion

Answer 5

Informed Player sends partly same and partly different signals (e.g. High: Left and Low: Mixes Left and Right)

Question 6

Adverse Selection

Answer 6

• Asymmetric information

- One player has information which the other player does not have