L15 - Asymmetric Information: Signalling I Flashcards
How can we help solve the adverse selection problem?
- In our previous topic, we saw that the welfare problems of moral hazard could be eased with (infinitely) repeated interaction and patient agents.
- Here, for adverse selection, repeated interaction cannot help in the same way because quality is exogenous and fixed. Instead, we will consider a different mechanism that can ease the welfare problems of adverse selection - signalling.
- Important: Do not confuse the two. (For our purposes, at least): i) repeated interaction and patient firms helps moral hazard, and ii) signalling helps adverse selection
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What is signalling used for?
- The key problem is that high quality sellers need to persuade consumers of their true quality in order to be able to trade.
- This is very general in adverse selection problems – at least one group of agents would prefer their private information to become common knowledge – (e.g. healthy, creditworthy, productive agents…)
- However, simply making a costless statement about their quality is not enough. It would not be credible.
- Why not?Because low quality firms would be willing and able to mimic the same statement. Such statements are then useless to consumers and provide no extra information. They are cheap talk
- Instead, to prove they are high quality, a high-quality firm would like to say or do something that is observable to consumers and impossible for the low quality firms to mimic.
- Unfortunately, this is not always possible.
- However, a high-quality firm might be able to say or do something that is observable to consumers and not optimal for the low-quality firms to mimic.
- In this way, consumers might then be able to distinguish high- and low-quality type firms in a way that allows trade with high quality products.
What do signalling models investigate?
Signalling models investigate the conditions under which agents can engage in such activities.
Essentially, signalling provides a fascinating theory of credible information transmission and communication.
Signalling can be applied to all sorts of contexts from investment banks to social relationships! It is a massively useful way to think about the world!!
What is the model of signalling with advertising?
- Extend last lecture’s model of adverse selection:
- Two periods. Quality is determined in period 1 and remains fixed throughout the game. Monopolist has a discount factor, δ .
- If the consumer buys in period 1, they learn the firm’s quality and so become fully informed in period 2.
- Monopolist can engage in advertising. Advertising has a marginal cost equal to one. So advertising an amount, A, costs A
- To highlight the role of signalling, we will assume that advertising has no direct effect on demand. –> just going to cost the monopolist A and the consumer is going to observe their advertisements
What is the payoff for the low-quality producer in the signalling with advertising model?
- Profits from mimicking the high type much be less than earning nothing at all
- Not ideal for them to signal
- refuse to buy in period 2
What is the payoff for the high-quality producer in the signalling with advertising model?
i) condition is for the low quality and is as follows
* (θ - CL) - A < 0
Combining both equilibrium condition we can derive the following property of A:
For such an Advertising level to exist in the equilibrium of the signalling model with advertising what also must be true?
- Within the separating equilibrium, advertising boosts welfare by enabling consumers to trade with a high-quality type.
- Hence, signalling can overcome some of the effects of adverse selection!
- However, there is still some damage to social welfare from asymmetric information. Unlike full information, the high type has to incur costly advertising
- If the conditions i) and ii) are not met, then no separating equilibrium will exist. Instead, there may be a pooling equilibrium. Here, the types behave similarly, so consumers cannot distinguish between them and the adverse selection problem remains.
derivation of the advertising second equation in the signalling with advertising model?
Technical note for the signalling model with advertising?
What is the overall intuition from the signalling model with advertising?
All that matters is that the advertising is observably costly, not necessarily what information it contains. ‘Burning money.
- Hence, signalling may be one explanation for the surprisingly high frequency of non-informative advertising.
- Perfume/Aftershave adverts don’t even talk about about their product they just show off celebs and these fancy location to demonstrate a life style, and the expensive ad set them apart from low quality competitors who wouldn’t do the same
- E.g. Abernethy and Butler (1992) review 4 studies of US TV ads. The average number of information cues is 1.06 and 37% have no information content.
- Signalling can also be used to explain any other observable, costly, expenditure: e.g. sponsorships, celebrity endorsement, expensive premises
Other applications of signalling?
- Can you apply signalling to explain some other behaviours from different areas of economics or everyday life?
- Dating
- restaurant –> menu and table cloth expensive (may not even have prices), how are the waiters dressed
- border school –> high prices
- high dividend payments (signal they are a good, strong company not going Anywhere)
- Biology –> male stags grow huge antlers to signal to female deers that they are good mates (even though they are heavy and effect their ability to eat)
- only strong stag survive as the weak ones wouldn’t be able to carry the antlers around and feed
Empirical Findings of Signalling?
Ackerberg (2001, 2003) analyses data on the yogurt, Yoplait. Advertising’s positive effect on purchasing declines as consumers become more experienced. Consistent with signalling (and also informative advertising).
Sahni and Nair (2020) run a very careful field experiment to show how sponsored search advertising can be a beneficial signal.
Hui et al (2016) establish the signalling value of eBay’s Top Rated Seller certificate. They show that it reduced adverse selection problems, and that consumers are willing to pay 4-9% more for a certified seller.
How can a high type signal they are better quality using a low price?
What is the separating equilibrium derived by a high type using low prices to signal?
