Chapter 5 Signalling Stefan P. Schleicher University of Graz Economics of Information Incentives and Contracts

1.Introduction How relevant is a university degree and the content of the degree? Formal education acts as a signal. This chapter analyzes situations in which one of the perties of a contract it interested in signalling some characteristic before the contract is signed.

2.The Value of Private Information and of Signalling (1) Private information distorts contracts since the agent attempts to take advantage of it. Moral Hazard Agent chooses an effort that maximizes his own expected utility, not the surplus of the relationship. Principal therefore offers a contract that gives the agent only the expected value of his reservation utility. Adverse Selection Pricipal offers contracts that ikmprove the average utility of those agents who are most likely to take advantage of the relationship.

2.The Value of Private Information and of Signalling (2) Because of the design of the contracts offered by the principal, some agents may be worse off under asymmetric information. Phenomen of signalling Agents may therefore have an interest to reveal their private information to the principal. The story of Bruce the Bold. In the same way firms search for workers with an ability to learn.

2.The Value of Private Information and of Signalling (3) Signal Some activity or some decision tht proves that the agent concerned has a certain ability or characteristic or possesses certain information, or – in other words – that the agent concerned belongs to a certain subset of the entire population.

3.Education as a Signal (1) Spence (1973) Education is used as a means of signalling good worker characteristics among candidates for some job. Agent 2 types – differ w.r.t. productivity productivity profits Type 1 (G for good)22 - w Type 2 (B for bad)11 - w Firms can’t distinguish the agent’s type

3.Education as a Signal (2) Education y time dedicated to education costs of education Type 1 (G for good)y/2 Type 2 (B for bad)y ASS.: Education has no effect on productivity

3.Education as a Signal (3) Firms’ beliefs as to the worker’s productivity, given an educational level Level of educationwage Type 1 (G for good)y  y*w = 2 Type 2 (B for bad)y < y* w = 1

3.Education as a Signal (4) Firms’ beliefs will be self-confirming  Level of education Type 1 (G for good)y = y*2 – y*/2  Type 2 (B for bad)y = 0 1 – 0  2 – y* therefore 1  y*  2

5.The Informational Power of Contracts Signalling effect of contracts. Principal has private information about two types of jobs Type 1 Type 2

5.1Symmetric Information (1) Optimal symmetric information contract for type 1 job Participation constraint Efficiency constraint

5.1Symmetric Information (2) Optimal symmetric information contract for type k job Participation constraint Efficiency constraint

5.1Symmetric Information (3)

5.2Agent is uninformed as to the difficulty of the job (1) Both types of principals prefer C 1 * If an agent reveives this offer, he does not know the type of agent and therefore will not accept it.

5.2Agent is uninformed as to the difficulty of the job (2) Contracts can transmit information which changes the agents beliefs about the probability q that the principal is of type 1.

5.3Seperating equilibria (1) A seperating equilibrium is one in which the contract offered perfectly identifies the principals type. Agent receives contracts and and adjusts his beliefs about the type of principal

5.3Seperating equilibria (2) Contract of principal k: Result 5.6: In a perfect Bayesian separating equilibrium it must always be true that

5.3Seperating equilibria (3) Restriction for contract of principal 1: Participation constraint Efficiency constraints

5.3Seperating equilibria (4)

5.3Seperating equilibria (5) Further restriction for contract of principal 1: Profits of a pessimistic type-1 principal

5.3Seperating equilibria (6)

6.Comments Companies signals for profitability New consumer goods guarantee period money-back guarantee Governments credible announcements The crucial role of believability