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Signaling and Screening June 12, 2007

Posted by jyu in Qualifying.
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Two types of information asymmetry:

  1. Hidden action (imperfect information) – Principal tries to induce the agent to take the single appropriate action
  2. Hidden type (incomplete information) – Principal tries to induce the agent to take the action that will reveal his type

Moral Hazard (in the context of hidden actions):

–A form of post-contractual opportunism that arises because actions that have efficiency consequences are not freely observable and so the person taking them may chose to pursue his or her private interests at other’s expenses

Adverse Selection (in the context of hidden types):

–Asymetric information about the pre-contractual information relevant to the transaction between the principal and agent

–The tendency of those in dangerous jobs or high risk lifestyles to get life insurance or seller has information about product quality but buyers don’t

Solutions to asymmetry information:

  1. Hidden actions: The principal develops incentive contracts (Mechanism)
  2. Hidden types: the informed party can use signaling while the uninformed party can use screening

Signaling: Agent conveys some meaningful information about himself to principal (signal before principal offers a contract)

Screening: Principal moves first or suggest a contract and learn agent’s type through his behavior (signal after a contract)

Examples:

  1. Manufacturer – Retailer: A manufacturer charges higher price or advertise more to convince that his product is in high quality (signaling).  A retailer asks “slotting allowance” to find the type of the product – high/low demand (screening)
  2. Used Car Trade: Seller proposed warranty/build reputation (signaling).  Buyer do a mechanic check on the car (screening)
  3. Education in the labor market: Employee obtains education to show that he is high performance type (signaling).  Employer chooses only graduate students expecting higher performance (screening)
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