Week 6: Adverse Selection Flashcards
signaling
signaling - the transmission of information between “biased” sources.
agent has private information or type. agent chooses a possibly costly action and principal infers type. This may separate high type from low type.
Examples: dating, firing, hiring
costly signaling
example
educational credentials
action costs a/t. t =1 and high type t=2. high type faces lower costs.
screening
uninformed part (principal) takes action. this is unlike signaling where informed party (agent) takes action.
principal designs scheme to elicit information. examples: internal promotion systems. this management section.
cheap talk
delegation and budget reports
two possibilities for info transmission: friendliness (used car salesman) and enforcement (audits)
separating equilibrium
different types take different actions. action informs uninformed player perfectly of type.
pooling equilibrium
different types take same actions. action is uninformative of type.
separating vs. pooling equilibrium example
separating equilibrium. Lisa goes to SIPA and Bart goes to NYU-Wagner. pooling: Lisa and Bart go to NYU Wagner.
MH vs AS
MH
hidden action a
principal pays wage according to outcome x
agent chooses a
prinicpals problem: a is unobservable, so there’s a motive for shirking. Example: agent’s effort on the job.
AS
hidden info, t
principal pays wage according to her updated assessment of t
agent chooses possibly costly option
principals problem: t is observable, so there’s a motive for low types (agents) to fool the principal.
Example: used car market, hiring
AS Signaling: separation vs. pooling
different types choose different actions (separation)
different types choose same action (pooling)
Ratchet Effect
no outside option
In period 1, agent chooses high/low action
In period 2, principal can exploit the high type by assigning more work
ratchet effect refers to a situation where workers subject to performance pay choose to restrict their output, because they rationally anticipate that firms will respond to higher output levels by raising output requirements or cutting pay
Noise
High noise when the outcome being
contracted on is affected by more than just
the agent’s efforts.
We call it noise if it is entirely random
Solution: change power of incentives
Example: Teaching and education (Dixit), farmers and weather
Number of tasks: Given two tasks, agents will divert their effort
from ____ task to the _____ task
Given two tasks, agents will divert their effort
from high noise task to the low noise task. Consolidate or separate tasks depending on
whether the different tasks are of different
noise levels
Example: Incentive pay for teachers based
on student test scores could result to
“teaching to the test” or cheating (Dixit)
Number of principals
Common Agency
Multiple principal demands suggest that
incentive structures will “net out” resulting in low-
powered incentives
Frequency of
Interaction
If noise is independently and identically
distributed, a principal can average out
performance to eliminate the effects of the noise.
High frequency of interaction allow the principal
to turn a high noise situation to a low noise
situation
Example: weather and farming
Attitudes towards Risk
Depending on who is more risk averse, affects contract design (power of incentives).
Example: sales division vs. admin division
