Microeconomics J Riley

American Economic Association
Silver Signals: Twenty-Five Years of Screening and Signaling

Author(s): John G. Riley
Source: Journal of Economic Literature, Vol. 39, No. 2 (Jun., 2001), pp. 432-478
Published by: American Economic Association
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Journal of Economic Literature
Vol. XXXIX (June 2001) pp. 432-478
S ilv er S ig nals : Twenty-Fiv e Y ears
of S creening and S ig naling
JOHN G. RILEY '
1. Introd uction
W HY IS IT s o hard to g et a g ood price
on a us ed car? Why is the annuity
market s o thin? Why d o firms offer lower
premiums per unit of cov erag e to in-
s urees who accept d ed uctibles ? Why d o
firms continue to pay d iv id end s , ev en
thoug h s harehold ers are s ubject to d ou-
ble taxation? Und er what cond itions can
a monopoly profitably d eter entry by s et-
ting a low "limit price" rather than the
monopoly price? Thes e are jus t a few of
the v as t array of ques tions that economic
theory was in no pos ition to ans wer until
the d ev elopment of new theoretical
found ations .
With the benefit of hind s ig ht, there
were four pioneer papers that s et the
s tag e for an unpreced ented res earch
effort that continues to this d ay.2 The
remarkable paper by William Vickrey
(1961) examined a rang e of is s ues in the
prov is ion of incentiv es when ag ents
hav e priv ate information. In the appen-
d ix, Vickrey ev en prov id ed a found ation
for mod ern auction theory. Ten years
later James Mirrlees (1971), in his
analys is of optimal income taxation,
prov id ed s ubtle ins ig hts into the trad e-
off between efficiency (the incentiv e to
work) and red is tribution. Around the
s ame time, Georg e Akerlof (1970)
s howed how trad e can almos t com-
pletely collaps e when ag ents on one
s id e of a market knowonly the d is tri-
bution of prod uct quality, rather than
the quality of each item trad ed .3 Finally
Michael S pence (1973) as ked whether,
in a competitiv e marketplace, s ellers of
abov e-av erag e quality prod ucts could
"s ig nal" this fact by taking s ome cos tly
action. On the other s id e of the market,
could the uninformed buyers us e the
cos tly action as a way to "s creen" for
quality?
In tod ay's terminolog y, the papers by
Vickrey and Mirrlees focus s ed on the
d es ig n of an incentiv e s cheme by an im-
perfectly informed monopolis t. Des pite
hav ing an informational d is ad v antag e, it
is typically the cas e that the monopolis t
has an incentiv e to offer a s et of alter-
nativ es that (at leas t partially) s eparates
out ag ents with d ifferent characteris tics .
In Mirrlees ' cas e, more able workers
1
Department of Economics , UCLA. I am in-
d ebted to S ara Cas tellanos and Felipe Zurita for
their as s is tance in the citation s earch, which
s erv ed to g uid e the s election of articles to be
includ ed , and for their us eful s ummaries . The
extens iv e and mos t helpful comments and s ug g es -
tions of Hong bin Cai, Jack Hirs hleifer, Bev erly
Lowe, the ed itor, and three referees are als o v ery
g ratefully acknowled g ed .
2
Ev en long after all of thes e papers were written,
the v ery s trong links were not fully und ers tood .
3
As ev id ence of how unus ual Akerlofs id eas
were perceiv ed to be, his paper was rejected by
two lead ing journals of the time.
432
Riley: S ilv er S ig nals 433
choos e to earn hig her income ev en
thoug h they knowthey will pay hig her
taxes . And in a Vickrey auction, buyers
with hig her v aluations hav e an incentiv e
to bid hig her. Akerlof and S pence ex-
amined mod els with a v ery s imilar for-
mal s tructure. Imperfectly informed
ag ents make offers , taking into account
the heterog eneity on the other s id e of
the market. Howev er, there is a key d if-
ference. Ins tead of a s ing le uninformed
ag ent, there is nowcompetition among
s uch ag ents . Thus , while Vickrey and
Mirrlees s tud y optimal incentiv e
s chemes , Akerlof and S pence examine
incentiv e s chemes that will s urv iv e the
competitiv e forces of the marketplace,
that is , equilibrium incentiv e s chemes .
One of the g reat theoretical contro-
v ers ies of this v as t literature is the char-
acterization of cond itions und er which
equilibrium incentiv e s chemes exis t.
This is a focus of s ection 2, which pre-
s ents the bas ic theory of "s creening ."
S ection 2 als o cons id ers s ituations in
which an informed ag ent mus t firs t "s ig -
nal" by taking a cos tly action, without
obs erv ing the terms und er which he
will be able to trad e. The critical ques -
tion is then how uninformed potential
trad ing partners will interpret the in-
formed ag ent's action. S uch a mod el
can only hav e s trong pred ictiv e power if
it is pos s ible to place s trong res trictions
on equilibrium beliefs .
Ad d itional theoretical s ubtleties are
examined in s ection 3. The next four
s ections look at many of the key
applications of the theory and attempt
to tes t the theory.4 S ection 4 focus es
on applications in ind us trial org aniza-
tion, s ection 5 in labor markets , and
s ection 6 in finance. S ection 7 prov id es
a brief introd uction to related papers in
macroeconomics .
2. Introd uction to the Theory
2.1 Hid d en Knowled g e and Ad v ers e
S election
Central to trad itional equilibrium
theory is the id ea that an economy
g uid ed by prices economizes on infor-
mation. In a priv ate g ood s world , ind i-
v id ual ag ents need to know nothing
about the other ag ents in the market-
place, and yet Walras ian equilibrium
prices res ult in a Pareto-Efficient allo-
cation. Critical to the id eal functioning
of the inv is ible hand , howev er, is the
requirement that ag ents hav e the s ame
information about the characteris tics of
the commod ities being trad ed . When
this as s umption fails , how to take full
ad v antag e of the potential g ains to trad e
becomes a much more s ubtle is s ue.
Akerlof (1970) prov id es the firs t for-
mal mod el, illus trating howd ramatically
as ymmetric information can affect equi-
librium trad es . Cons id er a population of
car owners , each of whom mus t choos e
whether to purchas e a newcar or hold
onto the old one. While us ed cars look
alike to potential buyers , the actual
quality v aries . Only the current owner
knows the actual quality of his car.
From the experience of prior period s ,
buyers correctly anticipate the av erag e
quality of us ed cars that are trad ed . The
market price of a us ed car thus reflects
the av erag e quality of a car on the mar-
ket. If quality d ifferences are larg e,
thos e with cars of s ufficiently hig h qual-
ity find it better to keep their old cars
rather than s ell, thereby lowering the
av erag e quality of cars being trad ed . As
Akerlof emphas ized , this incentiv e to
withd rawfrom the market can lead to
4The read er who is primarily interes ted in a
particular applied field may wis h to g o d irectly
from s ection 2 to the appropriate later s ection. In
almos t ev ery field , the literature is jus t too larg e to
s urv ey comprehens iv ely. A primary criterion for
s electing one paper to comment upon and not
another was the interes t g enerated by the paper
as meas ured by its citation count in the S ocial
S cience Citation Ind ex.
434 Journal of Economic Literature, Vol. XXXIX (June 2001)
an equilibrium in which none but the v ery
wors t cars (the "lemons ") are trad ed .
To und ers tand this , cons id er a
s tripped -d own v ers ion of Akerlofs
mod el. The market v alue of a car of
quality t is V(t) = a +
P3t,
where t is uni-
formly d is tributed on [0,1]. Giv en the
uniform d is tribution, the av erag e qual-
ity of us ed cars that are of quality t or
lower is V(t) = ax +
'P3t.
S uppos e that the
expected cons umer s urplus from the
purchas e of a new car is s . S uppos e
als o that only thos e us ed cars of quality
t' or lower are trad ed . Then the av erag e
market v alue of thes e cars is V(t'). If a
type t s eller hold s on to his us ed car
then his payoff is V(t). If he s ells , he
g ets the cons umer s urplus as s ociated
with the purchas e of a newcar and , for
his us ed car, a price equal to the av erag e
market v alue of s uch cars , V(t'). Thus ,
his total payoff from s elling his old car
and buying a newone is V(t') + s . Type t
is therefore better off hold ing on rather
than s elling if and only if V(t) > V( t') + s ,
that is ,
P3(t
- it') > s . In equilibrium, the
marg inal s eller mus t be jus t ind ifferent
between hold ing and s elling . Thus type
t' is the equilibrium marg inal s eller if
'Pt'=
s . All thos e with hig her quality cars
are better off opting out of the market.
In the limiting cas e, when s /l3 is v ery
s mall, it follows that the marg inal type t'
is s mall. Therefore the market for us ed
cars es s entially d ries up, with only the v ery
low-quality cars being trad ed . While s uch
an extreme outcome is pos s ible, the im-
portant obs erv ation is that it is the s ell-
ers of the hig her quality items who opt
out of the market. As ymmetric informa-
tion therefore ad v ers ely affects both the
v olume and quality of the items trad ed .
This phenomenon has long been und er-
s tood by the ins urance ind us try. Cons id er,
for example, the purchas e of an annuity
upon retirement. While an ins urance com-
pany can check current health, the cus -
tomer (the s eller of the ris k) knows
more about family long ev ity than the in-
s urance company (the buyer of the ris k.)
The s ellers with the g reates t long ev ity
s tand to g ain the mos t from the annuity
s ince they expect a long er s tream of pay-
ments . But, from the v iewpoint of the
buyers , thes e are the bad ris ks s ince they
will cos t the mos t. As a res ult, annuities
are expens iv e and the market is thin.
Obv ious ly, a neces s ary cond ition for
s uch a market failure is that the cos t of
es tablis hing a reputation for hones ty is
too hig h. Dev elopment economis ts hav e
noted that s uch problems tend to be more
prev alent in economies where market
ins titutions are more d ecentralized , and
there are larg e numbers of d irect s ales
by s mall s ellers .5 In more hig hly d ev el-
oped markets , it is the lowfrequency of
trad es by any s ing le s eller that makes
reputation-build ing prohibitiv ely cos tly.
We now illus trate ad v ers e s election
more formally in a richer mod el of in-
s urance. An ins urance contract X = (r,m) is
an ag reement by the ins urer that in
return for receiv ing a premium m it
will prov id e cov erag e r in the ev ent of a
los s L. Let pt be the probability of los s
for a type t ind iv id ual. For s implicity,
s uppos e that t E {1,2} and that the hig her
ind exed type is a better ris k (lower los s
probability.) Giv en an initial wealth W, and
s trictly concav e v on Neumann-Morg ens tem
utility function v (.), expected utility of
type t is
Ut(X)
= Ut(r,m) = (1 - pt)v (W - m)
+
ptv (W
- L + r-i)
It is read ily confirmed that expected util-
ity is a s trictly concav e function of the
contract terms X =
(r,m). The ind iffer-
ence curv e for each type throug h the
contract X is d epicted in fig ure 16
The s lope of this ind ifference curv e is the
marg inal willing nes s to pay an ad d itional
5
S ee, for example, Robert Klitg aard (1991).
6
For cons is tency with later d iag rams , the axes
hav e been inv erted in this fig ure.
Riley: S ilv er
S ig nals
435
Unbroken ind ifference
curv e of hig h ris k type
cov erag e
/
r
Das hed ind ifference
preference
curv e of lowris k
type
d irections
U2(X)= U2(X) __
m =
pr/
UJ(X) =UI(X)
+
m
premium
Fig ure 1. S ing le Cros s ing Property
and Ad v ers e S election
premium as the cov erag e increas es .
Intuitiv ely, the lower the probability of
los s , the s maller the ad d itional premium
an ind iv id ual is willing to pay for g reater
cov erag e. Thus , the d as hed ind ifference
curv e of the low-ris k type is flatter than
the unbroken ind ifference curv e of the
hig h-ris k type.7 As we s hall s ee, this
"s ing le-cros s ing property" of the prefer-
ence maps of d ifferent types is abs o-
lutely central to mod els of informational
as ymmetry.
Let
jp
be the probability of los s av er-
ag ed ov er the g ood and bad ris ks . Ig -
noring ad minis trativ e expens es , the ex-
pected profit on the contract X = (m,r)
for an ind iv id ual s elected at rand om
from the population is then
HI(X)= m -
jr.
Expected . - probability
profit premium of los s X Cov erag e
In fig ure 1, expected profit I1(X) is
pos itiv e in the interior of the s had ed re-
g ion below the zero profit line m
=)pr.
Note that the ind ifference curv e of the
low-ris k g roup is s ufficiently flatter that
7
It is read ily confirmed that the s lope of the
ind ifference curv e at X = (m,r)
aut
d m ar
d r Ut
aut
am
ptv '(W
- L + r -
m)
ptv '(W-L+r-m) + (1 -pt)v '(W-m)
increas es with Pt. Note als o that the s lope exceed s
Pt
if and
only
if
cov erag e
is
incomplete.
436 Journal of Economic Literature, Vol. XXXIX
(June 2001)
0
r
U2(X) U2(0)
H2(X)
=0
O
m =
p2r
U1(X) U1(X1)
F1(X)=O
m
m =
plr
premium
Fig ure
2.
S ing le Cros s ing
and
S creening
it lies below the no-ins urance point X =
(0,O).8 Thus , low-ris k types choos e not
to ins ure, leav ing only the hig h-ris k
types . This is another illus tration of
Akerlofs lemons principle. Howev er,
there is now a continuum of pos s ible
lev els of cov erag e. A complete analys is
thus requires that we cons id er d ifferent
lev els of cov erag e. We beg in by s uppos -
ing that ad v ers e s election has taken
place and that the hig h-ris k types are
the only ones g etting ins urance. Giv en
competition among ins urance companies
(and as s uming ins urance companies are
ris k neutral), the equilibrium contract
X1 is the utility-maximizing zero profit
contract for a hig h-ris k type.9 This is
d epicted in fig ure 2.
As in the prev ious fig ure, ind iffer-
ence curv es (and the zero-profit line)
for the low-ris k type are s hown as
d as hed curv es . Note that the d as hed in-
d ifference curv e for the low-ris k type
U2(X) = U2(0) g oes throug h the no-
ins urance point 0 and lies abov e the
contract X*. Thus , the low-ris k types are
ind eed better off out of the market
than purchas ing the ins urance contract
x;.
2.2 S creening
We will now arg ue that ins urance
companies hav e an incentiv e to "s creen"
for low-ris k types by offering a s econd
9 That is , X1 = arg
MaxtUI(X) I H1(X) 2 O}.
8
If the los s probabilities are s imilar, the ind if-
ference curv e lies abov e the orig in. Thus , for
ad v ers e s election to occur, the rang e of los s
probabilities mus t exceed s ome thres ho[d lev el.
Das hed ind ifference
curv e of lowris k type
cov erag e
r '
rI2(X) =0
U2(X) = U2(X) - ,
l(X)
0
,l(X)
=
ul(x-)
, premium
m
Fig ure 3. No Pooling Nas h Equilibrium
ins urance policy that prov id es lower
cov erag e. Cons id er the contracts in the
interior of the s had ed area in fig ure 2.
Thes e lie below the ind ifference curv e
UI(X) =
Ul(X*) and abov e the ind iffer-
ence curv e U2(X) = U2(0). Thus , they are
attractiv e only to the low-ris k types .
Moreov er, they als o lie below the zero
expected profit line F12(X) = 0 for the
low-ris k g roup. Thus any s uch contract
s creens for the low-ris k types and is
s trictly profitable.
Cons id er next the ins urance contract
X2 on the zero profit line rI2(X) = 0
bound ing the s had ed reg ion of profit-
able s creening . S pence (1973) in his
s eminal thes is arg ued that pairs of con-
tracts s uch as X1 and X2 were informa-
tionally cons is tent equilibrium contracts .
If firms offer thes e two contracts bas ed
on the belief that types will s eparate,
then thes e expectations are fulfilled .
Moreov er, the expected profit on each
contract is zero. Of cours e, exactly the
s ame arg ument hold s for all points on
the upper bound ary of the s had ed re-
g ion. This led to S pence's controv ers ial
conclus ion that there was a continuum
of informationally cons is tent equilibria.
While the id ea of an informationally
cons is tent s et of contracts appears to be
a natural g eneralization of Walras ian
equilibrium, it is incomplete in a num-
ber of ways . Firs t, there is no competition
in the s creening d imens ion. S econd , the
timing of actions is not s pelled out.
Third , the information s ets of the ag ents
are not fully s pecified . Thes e is s ues
were ind epend ently ad d res s ed by Riley
(1975) and Michael Roths child and
Jos eph S tig litz (1976). The latter paper
makes a more rad ical d eparture from
S pence's analys is by propos ing that the
mod el s hould be v iewed as a noncoop-
erativ e g ame between the uninformed
ins urance companies and the cons umers .
2.3 Roths child -S tig litz S creening
Gamel'
The g ame is d efined thus : Firs t, the
uninformed players announce offers .
S econd , each informed type choos es the
offer which is bes t for him. The offers
are a Nas h equilibrium s et of contracts
if, g iv en the s trateg ies of the other play-
ers , each uninformed ag ent's s trateg y is
a bes t res pons e.
The three key conclus ions about the
(pure s trateg y) Nas h equilibria of this
g ame are that: (i) d ifferent types are al-
ways s eparated , (ii) there is at mos t one
s eparating equilibrium, and (iii) equi-
librium exis ts if and only if the propor-
tion of hig h-v alue (low-ris k) types is
s ufficiently low. We nowlook at each of
thes e points in turn.
2.4 No Pooling
It is eas y to s ee that there can be no
Nas h equilibrium that pools the d if-
ferent types . Cons id er fig ure 3 and
s uppos e that the contract X is a Nas h
equilibrium. If it were s trictly profitable,
an ins urance company could offer a
s lig htly s maller premium and attract
ev eryone in the pool. Then X mus t jus t
break ev en. It follows that the flatter
zero-profit line for the low-ris k type,
n12(X)
=
0,
mus t be
as Ad epicted .
Note
that any offer s uch as X, in the interior
of the s had ed reg ion, is preferred ov er
X by only the low-ris k type. S ince s uch
offers als o lie below 112(X) = 0, they are
s trictly profitable. We hav e therefore
s hown that it is always profitable and
feas ible for an ins urance company to
s creen and "s kim the cream" from the pool.
2.5 Uniquenes s
We now s howthat there is at mos t
one Nas h equilibrium pair of contracts .
The informationally cons is tent contract
pair (X1,X2) from fig ure 2 is red rawn in
fig ure 4. Cons id er the ins urance con-
tract X. Low-ris k types are s trictly bet-
ter off choos ing X rather than X2, while
hig h-ris k types s trictly prefer X* ov er X.
Thus , the newoffer s ucces s fully s creens
for the low-ris k types . S ince X als o lies
below the zero-profit line for the low-
ris k types , it is s trictly profitable. Then
the pair of contracts (X1,X2) is not a
Nas h equilibrium. Exactly the s ame
arg ument hold s for any point to the
northeas t of X* on the zero-profit line
bound ing the s had ed reg ion. Thus , if
there is a Nas h equilibrium, it mus t be
the pair (X1,X2). Combining thes e arg u-
ments , we hav e s hown that if there is an
equilibrium (X1,X2) it has the following
properties : (i) X* is the bes t zero-profit
contract for the hig h-ris k types , and (ii)
X* is the bes t zero-profit contract for the
low-ris k types , which is jus t s eparating ."
2.6 Equilibrium
Thus far we hav e es tablis hed that if
there is an equilibrium it mus t be the
s eparating pair of contracts with the
minimum s eparation of the two types .
The final s tep is to d etermine cond itions
und er which there are no profitable d e-
fections from thes e contracts . Rather than
10
In the early literature, the terms "s creening "
and "s ig naling " are us ed almos t interchang eably.
More recently, it has become common to refer to
the g ame in which the uninformed ag ents mov e
firs t as a "s creening g ame" and a g ame in which
the informed ag ents mov e firs t as a "s ig naling
g ame." We s hall followthis conv ention.
11 This conclus ion g eneralizes immed iately to
the n type cas e.
Riley: S ilv er
S ig nals
439
U2(X)= U2(X2)
cov erag e
r/
r
0
112(X) = 0
//
IE
n2(X) n(x =
H,(X)=O
premium
m
Fig ure 4. Minimum
S eparation
of
Types
continue with the ins urance example, it
will be conv enient to s witch to a s imple
v ers ion of S pence's labor market mod el.
A type t ind iv id ual has a prod uctiv ity of
Vt(z)12 which is increas ing in both his
type and his lev el of ed ucation, z. An
employment contract X = (z,w) is an
ag reement to pay a wag e w to an in-
d iv id ual with ed ucation lev el z. The
worker's utility Ut(X) = Ut(z,w) is an in-
creas ing function of w and a d ecreas ing
function of z. Formally this mod el is
id entical in s tructure to the ins urance
mod el. Howev er, for expos itional reas ons ,
we follow S pence and make the further
as s umption that utility can be expres s ed
in the s eparable form Ut(z,w) = w- ct(z).
Then the s lope of an ind ifference curv e
for type t is :
aut
d w az
t
d z a Cut (Z)-
11t
12
While the literature s imply takes marg inal
prod uct as g iv en, the mod el is read ily g eneralized .
Let Vt(z) be the number of efficiency units of
labor s upplied by a type t worker. Then if the firm
hires
Lf
efficiency units of labor, and the output
price is p, the marg inal v alue prod uct of a type t
worker is
Vj(z.)
p
MPL(Lf)v t(z).
As s uming price-
taking behav ior, the firm ad d s workers until the
marg inal v alue prod uct of type t is equal to his
market wag e w(Zt).
ul(x)
=
ulU(xi U2(X)
=
U2(X2)
wag e / /
~~~~~~/ / /r
/' /" / ,' './ *,
,'?,"./ ,. ',J',r2(X)=O
.............................. / X (W V 2(Z))
*~~~~~~~ 1/ x2 '
w2
0111
/ X1 ,, X Preference
/ . . ~~~~~~~~~~~~~~~~~~d irections
/ ~* *,
Zl Z2 ~ ~ ~~~z Z
ed ucation
Fig ure 5. Labor Market S creening
The s ing le-cros s ing property hold s if the
marg inal cos t of ed ucation is lower for
more prod uctiv e workers . This is d e-
picted in fig ure 5 for the s imples t cas e of
two types .
In g raphical terms , the d as hed ind if-
ference curv es of a hig h-prod uctiv ity
(type 2) worker are flatter. Giv en our
as s umptions , the profit on a type t
worker who accepts the contract (z,w) is
IJIt(X)
= Vt(z) - w. The zero profit curv es
are als o d epicted in fig ure 5. The analy-
s is then proceed s exactly as in the ins ur-
ance example. The only potential Nas h
equilibrium is that in which the low
prod uctiv ity worker is offered his bes t
zero-profit contract and the lev el of
the ed ucational s creen is s et jus t hig h
enoug h to d eter low-prod uctiv ity work-
ers . Thes e two contracts X1 and X2 are
as d epicted in fig ure 6.
To complete the analys is , we need to
as k whether the unique cand id ate pair
of contracts X1 and X2 is a Nas h equilib-
rium. Fig ure 6 prov id es the ans wer. As
d epicted , the equilibrium ind ifference
curv e for the hig h-quality workers cuts
below the zero-expected profit line for
w
Ul(X)
= U(X)
wag e
U2(X)
=
U2(X)
///
///
__- / / tU'=V(z)
. X
s 'S >';g ~~~~~~~~~~~~00--/
2 ~~~~~~~~~~~~~.-..n.s .
>.,S : .......... : : .0..-,-. ... .. ... .. ..
_F . S . . t. . . . . . . . . . . . . . . . . -. - . . . . . . . . . . . . . . . .
-2
ed ucation
Fig ure
6. Nonexis tence of a
S creening Equilibriumn
a worker d rawn at rand om from the en-
tire population. Note that this will be
the cas e if and only if the fraction of
hig h-quality workers is s ufficiently hig h.
For then the curv e w= V(z) lies jus t un-
d er the corres pond ing curv e for the
hig h-quality workers W = V2(z). All con-
tracts in the interior of the s had ed re-
g ion are s trictly preferred by both types
of worker and g enerate s trictly pos itiv e
expected profits . Thus , the s eparating
pair of contracts , X1 and X2 is not a
Nas h equilibrium. Therefore, as empha-
s ized by Roths child and S tig litz, a
neces s ary and s ufficient cond ition for
equilibrium is that the proportion of
hig h-quality workers s hould not be too
hig h.
Riley (1985) extend s the analys is by
as king what s ort of as s umptions about
preferences are s ufficient for equilib-
rium. S uppos e that we fix the technol-
og y, the d is tribution of types and the
preferences of
low-q3uality
workers .
Cons id er the contract X in fig ure 6. This
lies below the curv e w= V(z) if and only
if the v ertical d is tance w2 -W2 is s uffi-
ciently larg e relativ e to w_ -
A
. But the
A
contracts X2 and X lie on the s ame ind if-
ference curv e for a hig h prod uctiv ity type.
Thus ,
U2(z2,w2) = W2- C2(Z2)
A /A
(TA'A\
= W2
-
C2(Z2)
=
U2 Z,W2),
and therefore w2 - W2 = C2(Z2) - c2(z). A
s ymmetrical id entical arg ument for type
1 workers es tablis hes that w2 - Wl =
c2(z2)
- cZ(z). Therefore
* A * (A
W2-W2
C2(Z2)-C2 Z)
* A
C(*
A-
W2-Wlc2(z ) C1kZ)
We hav e arg ued that equilibrium fails
to exis t if and only if the left-hand s id e
is s ufficiently larg e. Thus , for equilib-
rium, the ratio of ed ucational cos ts
mus t be s ufficiently s mall. This will be
the cas e if the marg inal cos t of ed uca-
tion is s ufficiently lower for the hig h
quality type. The central conclus ion is
that it is not enoug h for preferences to
s atis fy the s ing le cros s ing property.
Ins tead , the preference maps of the d if-
ferent types s hould v ary s ufficiently
rapid ly with type.
2.7 Monopoly S creening
With a s ing le uninformed ag ent, the
optimal s creening mechanis m is s uper-
ficially v ery s imilar. Cons id er our labor
market example once more. S uppos e there
is a s mall s upply of low-prod uctiv ity
workers s o that the monopolis t maxi-
mizes profit by hiring both types of
worker. For s implicity, s uppos e both
types hav e the s ame res erv ation wag e
WR. The monopolis t maximizes profit on
type 1 workers by maximizing profit,
Hli(z,w)
=
Vi(z)
-
w, s ubject
to the con-
s traint that Ul(z,W)
?
WR. This is the
contract Xi in fig ure 7.
To be incentiv e compatible, a hig h-
quality (type 2) worker mus t be at leas t
ind ifferent between the offer he ac-
cepts and Xi. Thus his offer mus t be on
or abov e the heav y d as hed ind ifference
curv e. The monopolis t then maximizes
profit on a type 2 worker IH2(X) = V2(z) -
w s ubject to the cons traint that U2(X) >
U2(X1).
Note that at Xt, t = 1,2, the s lope of
the ind ifference curv e
c'l(z)
is equal to
the s lope of the is o-profit curv e V't(z).
Thus both contracts are efficient. We
will now arg ue that the monopolis t can
always d o better by lowering the ed uca-
tional requirement for the low type.
The res ulting pair of contracts is
XKMi
and
Xm. Note that this chang e red uces the
profit on low-prod uctiv ity workers and
rais es the profit on hig h prod uctiv ity
workers . But, s tarting from the contract
Xi and mov ing around the type 1 res er-
v ation ind ifference curv e, the is o-profit
curv e and ind ifference curv es are locally
of the s ame s lope. Thus , in the neig h-
borhood of Xi, the los s in profit on a
type 1 worker is of s econd ord er, while
the g ain in profit on a type 2 worker is
of firs t ord er.
As is the cas e for the R-S s creening
mod el, the monopolis t maximizes profit
by s eparating low- and hig h-quality
workers . Howev er, there is an impor-
tant d ifference. Note that now it is the
hig h-prod uctiv ity worker who is offered
an efficient contract while the low-
prod uctiv ity worker achiev es a s ub-
optimal ed ucation. The oppos ite con-
clus ion hold s for the Nas h equilibrium
of the R-S s creening g ame. In the
monopoly mod el, the firm s acrifices
efficiency at low-quality lev els in ord er
to extract more s urplus from hig h-
prod uctiv ity workers . In the "competi-
tiv e" s creening mod el, firms s acrifice
efficiency at hig h-quality lev els in or-
d er to s eparate hig h- from low-quality
workers .
The earlies t formal mod eling of mo-
nopoly s creening is Mirrles s ' (1971)
remarkable paper on income taxation.
w
wag e
U2(X)
=
U2(XI)
ed ucation
Fig ure 7. Monopoly S creening
S uppos e we reinterpret the v ertical axis
of fig ure 7 as g ros s income and the
horizontal axis as tax. Then, as Mirrlees
obs erv ed , the trad e-off between income
and taxation d iffers , becaus e ind iv id uals
of d iffering ability hav e d ifferent oppor-
tunity cos ts of leis ure. Then the tax
authority choos es among incentiv e com-
patible tax-income pairs (X1,X2) to
achiev e its s ocial objectiv e. This paper
and the clos ely related work by Vickrey
(1961) on auction choice has s ince
s purred a v as t literature on the d es ig n
of incentiv e s chemes by an unin-
formed "principal." Much of this litera-
ture has at its core the s ing le cros s ing
property.
2.8 S ig naling
In the R-S s creening mod el, it is the
uninformed ag ents who hav e the critical
role. They us e their knowled g e of d if-
ferences in preferences to s creen for
d ifferent quality lev els . The informed
ag ents s imply res pond to the offers
mad e by the uninformed . But what if it
is the informed ag ent or ag ents who
mus t mov e firs t? For example, what if a
firm has d ev eloped a new prod uct or
s erv ice whos e quality is not eas ily ev alu-
ated by potential buyers ? Is there s ome
way that the firm can, throug h a cos tly
action, "s ig nal" to buyers that it is s elling
a hig h-quality prod uct?
To ans wer thes e ques tions , we return
to S pence's labor market mod el and ex-
plore the implications , und er the new
as s umption that it is the informed ag ent
who mus t mov e firs t.13 In this s ig naling
g ame, firms are s eeking to hire a new
type of technolog y cons ultant who may
be of hig h or low quality. Cons id er fig -
ure 5 once more and the pair of ed uca-
tion lev els zt and Z2. S uppos e that the
cons ultant's s trateg y is to choos e the
hig her ed ucation lev el if and only if his
quality is hig h. If firms believ e this , it is
a Nas h-equilibrium bes t res pons e to
pay a wag e equal to the perceiv ed mar-
g inal prod uct. Thus a cons ultant with
ed ucation lev el z* is offered a wag e
I
= Vi(zt), while a cons ultant with ed u-
cation lev el Z2 iS offered a wag e W2 -
V2(Z2). Giv en s uch offers , it is clear
from fig ure 5 that the cons ultant is bet-
ter off choos ing the hig her ed ucation
lev el if and only if he has a hig h mar-
g inal prod uct. The pair of contracts X1
and X2 are thus Nas h equilibrium con-
tracts . By the s ame arg ument, there is a
continuum of equilibria with the hig h-
quality contract lying on the curv e
H2(X)
=
0, between X2 and X2. Ind eed ,
as In-Koo Cho and Dav id Kreps (1987)
s howed , all the equilibria d is cus s ed by
S pence are Bayes ian-Nas h equilibria of
this g ame.
With the better-informed ag ent mov -
ing firs t, the critical is s ue is how a les s -
informed ag ent will res pond to s ome
unanticipated action by the firs t mov er.
Unfortunately, there is nothing in the
formal d es cription of a Nas h equilib-
rium to res trict s uch beliefs . One of the
key innov ations of mod ern g ame theory
is the d ev elopment of ways to "refine"
beliefs . Among the leas t controv ers ial of
thes e id eas is that the equilibrium be
"s equential" (Kreps and Robert Wils on
1982). In the s ig naling g ame, this re-
quires that the s econd mov ers as s ig n a
probability d is tribution ov er types for
ev ery pos s ible action by the firs t mov er
and , hence, a bes t res pons e Wbr(Z) to
ev ery feas ible s ig nal z. Giv en thes e bes t
res pons es , the Nas h equilibrium is s e-
quential if the firs t mov er has no incen-
tiv e to chang e his s trateg y. Cons id er
then the Nas h equilibrium s trateg ies z*
and Z2 in fig ure 5. If firms believ e that
low prod uctiv ity cons ultants are s uffi-
ciently more likely to take s ome out-of-
equilibrium lev el of the s ig nal z, the
bes t res pons es will be low wag e offers .
Giv en thes e low wag e offers , it follows
that a hig h quality cons ultant is wors e
off d ev iating . Thus , there is a continuum
of (s equential) Nas h equilibria.
Cho and Kreps (1987) arg ue that out-
of-equilibrium beliefs s hould be further
refined . If a cons ultant takes an out-of-
Nas h-equilibrium action Z, then firms
g o throug h the following "intuitiv e"
exercis e.
(1) If all the uninformed firms believ e it
is a type t cons ultant who chos e z,
what will be the hig hes t wag e of-
fered ? Let the res ulting contract be
A
(A, WA). X= zw
(2) Would a type t cons ultant be s trictly
better off with the contract X than
with his Nas h equilibrium contract?
(3) Is it als o the cas e that no other
type would be better off s witching to
contract X?
If the ans wer to both (2) and (3) is yes ,
Cho and Kreps arg ue that a type t con-
s ultant has an incentiv e to d ev iate. That
is , the pair of contracts X* and X2 fails
their "intuitiv e criterion."
In fig ure 5, any ed ucation lev el Z2
s trictly g reater than z2 fails the intuitiv e
criterion. If firms believ e that the d ev ia-
tion to Z is by a hig h-quality cons ultant,
they will bid his wag e up to w=V2 z).
13
We will cons id er s ig naling g ames in which
there is more than one uninformed ag ent. Hav ing
only a s ing le ag ent chang es the outcome, but not
the method of analys is .
This is s trictly preferable for a hig h-
quality cons ultant, but s trictly wors e for
a low-quality cons ultant. Thus , the be-
lief that it is a hig h-quality cons ultant is
s us tained .
S imilar arg uments es tablis h that there
can be no pooling equilibrium when the
intuitiv e criterion is applied . Thus the
unique Nas h equilibrium pair of con-
tracts , which als o s atis fies the intuitiv e
criterion, is the pair X1 and X2.
The intuitiv e criterion has d ominated
the literature in the years s ince its in-
trod uction. From the pers pectiv e of ap-
plied res earch, it is eas y to und ers tand
why. Gone are the problems of non-
exis tence that make applied theoris ts
uneas y about the Roths child -S tig litz
g ame. Gone als o is the continuum of s e-
quential Nas h equilibria. Ins tead , g iv en
the s ing le-cros s ing property, the theory
yield s a well-s pecified pred iction of full
s eparation of types . Unfortunately, the
theory is not as tid y as it mig ht appear.
Cons id er fig ure 6. Applying the intui-
tiv e criterion yield s the unique s eparat-
ing equilibrium contracts X1 and X2.
S uppos e the cons ultant d ev iates and
choos es ed ucation lev el z^. S uppos e als o
that there is only a v ery s mall prob-
ability that the cons ultant is of low
quality. Then the heav y curv e w=V(z)
repres enting the av erag e prod uctiv ity
acros s the two quality lev els is ex-
tremely clos e to the hig h-quality zero
profit curv e w= V2(z). How will firms
res pond to s uch a d ev iation? S anford
Gros s man and Motty Perry (1986) ar-
g ue as follows . Let Tbe the s et of all
types (here T=
{1,2}) and let S be s ome
s ubs et of T. In the s pirit of the intuitiv e
criterion, the following ques tions need
to be as ked .
(1) If all the uninformed firms believ e it
is a type from S who chos e z^, and
upd ate their beliefs us ing Bayes
Rule, what will be the hig hes t wag e
offered ? Let the res ulting contract
be X= (z,w).
(2) Would any cons ultant of type t E S be
s trictly better off with the contract X
than with his Nas h equilibrium
contract?
(3) Is it als o the cas e that no other type
would be better off s witching to
contract X ?
If the ans wer to both (2) and (3) is yes ,
Gros s man and Perry (G-P) arg ue that a
cons ultant whos e type is in S ind eed has
an incentiv e to d ev iate. Of cours e, if the
s ubs et S is a s ing leton, the G-P criterion
red uces to the intuitiv e criterion.
In fig ure 6, let the s ubs et S be both
types . As long as the probability of a
hig h type is s ufficiently hig h, there is a
s had ed reg ion of profitable res pons es
which are s trictly preferred by both
types . Thus the unique Cho-Kreps
equilibrium fails the G-P criterion. It
follows that there is no equilibrium
s atis fying the G-P criterion. Ind eed , an
equilibrium of the s ig naling g ame fails
to exis t in precis ely thos e s ituations
where there is no equilibrium of the
Roths child -S tig litz s creening g ame.
My v iew on all of this is that it is v ery
hard to make a cas e in fav or of the Cho-
Kreps criterion without als o prov id ing
s upport for the more s tring ent G-P
criterion. S ince I find the intuitiv e cri-
terion pers uas iv e, I am unable to reject
the G-P criterion. I am therefore forced
to conclud e that there will not always
be a cred ible equilibrium. This s hould
not be too s urpris ing . In trad itional
equilibrium theory, problems for equi-
librium often occur whenev er there are
externalities . Here it is the preferences
of the low-quality types which cons train
the profitable alternativ es of hig her
quality types . The more s imilar are the
preferences of the two types , the
g reater the neg ativ e informational ex-
ternality. As we hav e alread y s een, it
is pos s ible to characterize cond itions
und er which there exis ts a s eparating
equilibrium und er the more s tring ent
G-P criterion. The critical requirement
is that the rate at which the marg inal
cos t of s ig naling d eclines with quality
mus t be s ufficiently hig h.
3 Further Theoretical Dev elopments
3.1 S creening with Many Types
One of the limitations of the bas ic mod el
is the as s umption that there are only
two types . It is natural to as k whether
the d ifficulties are compound ed as the
number of types increas es . To illus trate
the is s ues inv olv ed , we focus on a s im-
ple labor market example in which
there is a continuum of types . Cons id er
the R-S s creening g ame. S uppos e that
prod uctiv ity of type t is V(t), that is , the
s ig nal has no d irect effect on prod uc-
tiv ity. S uppos e als o that types are con-
tinuous ly d is tributed with s upport [oc,,].
The cos t of an ed ucation lev el z is
C(t,z), where the marg inal cos t of
ed ucation is a d ecreas ing function of
type.
As in the two-type cas e, it is not d iffi-
cult to characterize the equilibrium
(as s uming it exis ts .) Firs t, arg uing as in
the two-type cas e, there can be no
equilibrium pooling . We then s eek a
s eparating equilibrium. Giv en a wag e func-
tion w(z), type t choos es his ed ucation
lev el zs (t) to maximize his payoff
U(t,z,w) = w(z) - C(t,z). (1)
For complete s eparation, zs (t) is s trictly
increas ing and s atis fies the firs t ord er
cond ition,
w'(zS (t)) - -C(t,zs (t)) = 0. (2)
az
In equilibrium, the marg inal profit on
each type is zero. Thus , the wag e that
type t choos es mus t be equal to his mar-
g inal prod uct; that is ,
w(zS (t)) = V(t) (3)
To clos e the mod el we need to d etermine
the s ig nal chos en by the lowes t type.
But, we can arg ue exactly as with two
types , that the only feas ible ed ucation
lev el for type ac is the full-information
efficient lev el zs (oc).
We nowes tablis h that the s eparating
wag e function w(z) s atis fying thes e con-
d itions is not a Nas h equilibrium.14
Choos e tv s o that type t is ind ifferent
between his s eparating contract (zs (t),
w(zs (t)) and
(zs (ac),fl).
That is ,
U(t,zs (oc), A)
=A_
wC(t,zs (oc))
= w(zs (t))
-
C(t,zs (t)).
Giv en the s ing le cros s ing property, s uch
a wag e offer is s trictly preferred by all
types les s than t. Let V(t) be the ex-
pected marg inal prod uct of types les s
than t. S ubs tituting from equation (4),
the expected profitability of this offer is
El(t) = V(t) - = V(t) - w(zs (t))
+ C(t,zs (t) -
C(t,zs (0()).
Differentiating by t and collecting terms ,
171'(t)
=
V'(t) -W(ZS (t))
-
a C(t_ZS (t))
+
a
C(t,zs (t))
-
a
C(t zs (a))].
From the firs t ord er cond ition, (2), the
firs t bracketed expres s ion is zero. In
the limit, as t approaches oc, the s econd
bracketed expres s ion is zero. Thus ,
[i (a)
= V'(c) > 0.
S ince H(ac)
=
0, it follows that at the
ed ucation lev el zs (oc), any wag e which
exceed s V(oc) and is s ufficiently clos e
g enerates pos itiv e expected profits .
This g eneral nonexis tence res ult is , at
firs t s ig ht, d ev as tating to the theory.
14The arg ument belowd oes not s eem to hav e
appeared in print. The res ult was d is cus s ed , how-
ev er, in unpublis hed d rafts of Riley (1975) and
Roths child and S tig litz (1976).
Howev er, the res ult hing es on the as -
s umption that all types would enter the
ind us try und er full information. S up-
pos e ins tead that there is an equilib-
rium thres hold for the types who
choos e to s ig nal. For example, s uppos e
that each worker has a res erv ation wag e
WR (an opportunity in s ome d ifferent in-
d us try). If this wag e wR =
V(y)
> V(oc),
there is an interv al of types [oc,y]
who
are better off in the other ind us try.
(Remember that, in a s eparating equi-
librium, each type is paid his marg inal
prod uct.) Then the lowes t wag e among
thos e who choos e to s ig nal is
V(y).
It
follows that rais ing the wag e at zs (oc) at-
tracts all thos e who would otherwis e ac-
cept the res erv ation wag e. If this pool is
s ufficiently larg e, the offer los es money.
Thus far I hav e focus ed on the criti-
cal problem at the lower end point of
the wag e d is tribution. As long as this
problem can be d ealt with s atis factorily,
it is pos s ible to d eriv e s ufficient cond i-
tions for exis tence for a fairly g eneral
v ers ion of the bas ic S pencian mod el,
with a continuum of types (Riley 1979b,
1985). The key ins ig ht is that there ex-
is ts a Nas h equilibrium, as long as the rate
at which the marg inal cos t of s ig naling
d eclines with type is s ufficiently hig h.
Moreov er, this equilibrium is unique
and completely s eparates the d ifferent
types .
3.2 Alternativ e Equilibrium Concepts
Giv en the nonexis tence res ults for
the s imple s tatic mod el, Charles Wils on
(1977) beg an the exploration for s ta-
tionary points of a d ynamic ad jus tment
proces s . He noted that if new profitable
offers lead to los s es for other offers , the
latter mig ht be quickly withd rawn.
Bas ed on this id ea, he then weakened the
Nas h Equilibrium concept by requiring
that any new offer remain profitable af-
ter the withd rawal of los s -making offers .
A s et of contracts W is a Wils on equilib-
rium if, for any ad d itional offer X (or
s et of offers ) that is s trictly profitable,
when the full s et of offers is W U X, the
new offer los es money when unprofit-
able offers in W are d ropped . Wils on
prov ed a g eneral exis tence res ult and
s howed that, whenev er there is no Nas h
s eparating equilibrium, the Wils on
equilibrium (i) has fewer offers than
types s o there is s ome pooling and (ii)
Pareto d ominates any fully s eparating
s et of zero-profit contracts .
A s imilar arg ument along thes e lines
prod uces a quite d ifferent res ult. In a
reactiv e equilibrium, firms react by
ad d ing new profitable contracts rather
than d ropping old ones . S tarting from a
s eparating s et of zero-profit contracts ,
any ad d itional offer, X, inv olv es pooling
of d ifferent types . But, if the pool is
profitable, profits on the bes t in the
pool are ev en more profitable. As Riley
(1979) s howed , there are always s creen-
ing reactions that s kim the cream and
res ult in los s es for the offer X. A s et of
offers , R, is a reactiv e equilibrium, if,
for any ad d itional offer X that is profit-
able, that contract los es money when
firms ad d profitable "reactiv e" offers . It
turns out that the Pareto d ominating s et
of s eparating zero-profit contracts is the
unique reactiv e equilibrium.
Rather than weaken the equilibrium
concept, Martin Hellwig (1987) chang es
the rules of the g ame. He s hows that
the Wils on equilibrium is a Nas h Equi-
librium of a g ame in which the unin-
formed hav e two round s of play. In the
firs t round each uninformed ag ent offers
as many contracts as he wis hes . The full
s et of contracts is then mad e public. In
the s econd round each uninformed ag ent
then has an opportunity to withd raw as
many of his firs t round offers as he
wis hes . The informed ag ents then s elect
from the s et of contracts remaining af-
ter the s econd round . At leas t for the
two-type cas e, it is eas y to s ee that the
w
wag e
UIM Ui(X')
U2(X) =U2(XW)
V
XW
V1
ed ucation
Fig ure
8. Wils on
Equilibrium
Wils on
equilibrium
is a Nas h
equilib-
rium of this two-round
g ame.
Cons id er
the cas e of two firms . The
marg inal
prod uct
of
type
2 is V2 and the
expected
marg inal prod uct
of a worker d rawn
rand omly
from the
population
is V. We
will
arg ue
that the Nas h
equilibrium
of
this
g ame
is the Wils on
pooling equilib-
rium Xw.
S ~uppos e
that firm A choos es the
contract X in round 1 and round 2,
rather than Xw. To be
profitable,
firm
I's offer mus t lie in the s had ed
reg ion
in
fig ure
8. S ince this leav es
only type
1
accepting
the offer
Xw~,
the latter is un-
profitable
and s o firm B's bes t
res pons e
in round two is to
d rop
its offer.
A
Te
all
accept
the
remaining
contract X. But
Xw~ is a
zero-profit
contract thus X mus t
yield
los s es . It follows that firm A is
s trictly
better off choos ing Xw.
For the
two-type cas e, it is
eas y
to
s ee that the reactiv e
equilibrium
can
als o be v iewed as the
equilibrium
of a
multi-round
g ame.
The
only
d ifference
is that
players g et
an
opportunity
to
make ad d itional offers in the s econd
round , rather than
d rop
offers . Let
(XR',XR2)
be the reactiv e
(s eparating )
equilibrium. Any profitable
d ev iation X
mus t
pool
the two
types . Then, in round
2, it is always pos s ible to s kim the
cream with an ad d itional offer. This
leav es the bad workers choos ing X and
s o the d efecting firm end s up with
los s es .
One d ifficulty with mod ifying the
rules of the g ame in this way is that it is
hard to know when to s top. A third pos -
s ibility would be to allow firms to either
ad d or d rop offers in the s econd round .
I conjecture that both the Wils on and
reactiv e equilibria are Nas h equilibrium
of this new g ame.
More fund amentally, telling a s tory
about a hypothetical ad jus tment proces s
to jus tify a s tatic equilibrium is a poor
s ubs titute for a formal d ynamic mod el.
S pence, in his early work, s ug g es ted that
if competition were s ufficiently fierce,
the outcome would mos t likely be s ome
form of cycle. Recently, theoris ts hav e
beg un analyzing s creening us ing s imple
ev olutionary d ynamics . Build ing on the
work of M. Kand oori, Georg e Mailath,
and Rafael Rob (1993) and Peyton
Y oung (1993), Georg Nold eke and
Larry S amuels on (1997) built a formal
ev olutionary mod el for the two-type cas e.
They s how that if there is no Nas h equi-
librium of the Roths child -S tig litz one-
s hot g ame, the ev olutionary d ynamical
s ys tem d oes not hav e a s tationary point.
Ins tead there is an equilibrium two-
period cycle that is s table in the face of
low-frequency perturbations . The hig h-
v alue types always choos e the more
cos tly action ZH while the low types
s witch back and forth between ZH and
s ome les s cos tly action ZL. S uppos e that
in period t all workers choos e ZH. Then
firms find that the av erag e prod uctiv ity
is V(ZH). Firms bas e their offers next
period on this period 's obs erv ations and
thus offer a wag e WH(t + 1) = V(ZH). This
is s ufficiently low that low-quality work-
ers are better off choos ing ZL and re-
ceiv ing a wag e WL(t + 1)
=
VL(ZL). The
prod uctiv ity of workers choos ing ZH
then ris es to VH(ZH). Firms obs erv ing
this outcome then offer a wag e
WH(t+2)= VH(ZH) and the cycle beg ins
ag ain. While this s eems to be a poten-
tially promis ing res earch prog ram, much
work remains to be d one. In particular,
it will be important to und ers tand the
cond itions und er which equilibria can
be read ily characterized with more than
two types . Moreov er, s urely the s imple
ad aptiv e expectations mod el is too
naiv e. Pres umably firms would beg in to
und ers tand the cycle and thus make
wag e offers bas ed on the expectation of
a continuing cycle.
3.3 S ig naling
With the informed ag ents mov ing
firs t, we hav e s een that there is a con-
tinuum of Nas h s ig naling equilibria.
For equilibrium theory, the central
ques tion is whether it is pos s ible to
place s ens ible res trictions on beliefs
that then s upport a much s maller s et of
equilibria. As noted in s ection 2, it is
typical to appeal to the Cho-Kreps in-
tuitiv e criterion. Unfortunately, while this
criterion s ucces s fully s elects a unique
equilibrium in the bas ic s ig naling
mod el, it need s to be s treng thened to
hav e any bite when the as s umptions of
the mod el are relaxed only s lig htly.
Cons id er the s imple cons ulting exam-
ple. As in the bas ic two-type mod el,
each type has a marg inal prod uct that is
hig h or low. A type 1 cons ultant has a
lowmarg inal prod uct and a hig h cos t of
s ig naling , while a type 2 cons ultant has
a hig h marg inal prod uct and a lowmar-
g inal cos t of s ig naling . There is als o a
s mall probability that the cons ultant is
of type 3 or type 4. Type 3 has a mar-
g inal cos t of s ig naling s lig htly lower
than type 2 and type 4 has a marg inal
cos t of s ig naling s lig htly hig her than
type 2. Both hav e a lowmarg inal prod -
uct. S ince types 2, 3, and 4 hav e v ery
s imilar s ig naling cos ts , we look for an
equilibrium in which they are all
treated alike. Let V234 be the expected
prod uctiv ity of a cons ultant of types 2,
3, and 4. S ince the cond itional prob-
ability is hig h that he is type 2 rather
then types 3 or 4, V2 - V234 is s mall.
Cons id er the pair of contracts
(X1,X234) in fig ure 9. S ince X1 is a bes t
res pons e for type 1 and X234 is a bes t
res pons e for the other types , both con-
tracts jus t break ev en. Thus (X1,X234) is a
Nas h equilibrium.
S uppos e that the cons ultant choos es
the out-of-equilibrium s ig nal z^. As d e-
picted , ev en if firms were to pay the
hig h marg inal prod uct (the contract X
in fig ure 9) type 1 would be wors e off
choos ing z rather than zt. Thus by the
intuitiv e criterion, only types 2, 3, and 4
could pos s ibly g ain. Howev er, the crite-
rion is s ilent as to what res trictions
s hould be placed on beliefs about the
likelihood that it is a type 2 cons ultant
rather than a type 3 or type 4 15
The "propernes s " criterion propos ed
by Rog er Myers on (1978) focus es on
the relativ e ad v antag e to d oing s o. In a
proper equilibrium almos t all the
weig ht is placed on the type who g ains
the mos t from the d efection. S ince type
4 has a larg er marg inal cos t than types 2
and 3, propernes s as s ig ns almos t all the
weig ht to type 4. Giv en s uch beliefs , it
follows that firms would offer a wag e too
lowto be attractiv e to any type. Then
the Nas h equilibrium is proper. Ind eed
any s eparating Nas h equilibrium is
proper.
Rather than look d irectly at payoffs ,
Jeffrey Banks and Joel S obel (1987)
compare the s ets of res pons es that
would make the worker better off. If
the s et for type 4 is s trictly larg er than
for type 2, Banks and S obel require that
the rev is ed probability that the worker
15
An almos t id entical arg ument hold s for
s ig nals
g reater than Z234.
450 Journal
of
Economic
Literature,
Vol. XXXIX
(June 2001)
w
wag e*
U1(X) = U1(Xl)
U4(X) =
U4(X234)
wae U)
// U2(X)
=
U2(X234)
/~~ ~~~ A U//X =
V2
.7
7' t
...U3(X)
=U3(X234)
_~~~~~~~~~~
X23 / ,-/--
x~~~~~~
w21 = V234
X1
',
-~ ~~~~~~~~~~~ /
O
-l
Z234 Z Z234
s ig nal
F 9
w
.........
2
. . .. . . .. . . . .. . . .. . . .. . . . .. . . .. . . .
- -
W
4 ........................0O
. . ... .....
- -
w1=V1 ~~~~~~~~~~0
10
o z s ig nal~~00
Fiue9 otnumo qulbi
is type 4 rather than type 2 s hould not
fall below the prior probability. In this
example, all wag es abov e W4 make type
4 better off and all wag es abov e
W2 make type 2 better off. Thus the
probability placed on type 4 mus t ris e.
In particular, the Banks -S obel criterion
d oes not rule out the belief that it is
hig hly likely that the d efector is type 4.
With s uch a belief, the res pons e is a low
wag e offer. Thus , jus t as with propernes s ,
there is a continuum of Banks -S obel (or
"Div ine") equilibria.
Elon Kohlberg and Jean-Francois
Mehrtens (1986) propos e to res trict the
s et of Nas h equilibria to thos e that are
equilibria of the entire family of g ames
that hav e the s ame normal form as the
orig inal g ame. In particular, s uppos e
that the players can choos e either to
play the g ame in round 1 or choos e not
to play and then play the g ame in round
2. This mod ified g ame is d epicted below.
Let the g ame in the box be the s im-
ple cons ulting example with the four
d ifferent types (whos e preferences are
as d epicted in fig ure 9.) S uppos e that
the Nas h equilibrium (X1,X234) is played
in the upper box in fig ure 10. Cons id er
a type who choos es "Don't Play" in
round 1 and then the s ig nal z. S ince the
hig h marg inal prod uct is V2, the mos t
that any firm will offer in res pons e is a
wag e w= V2. This is the contract X in
fig ure 9. As d epicted , type 1 s trictly
prefers his Nas h equilibrium payoff to
this contract. That is , his Nas h equilib-
rium payoff s trictly d ominates ("Don't
Play
Gm
g ame Game
cons ultant
Don't Play
play
ulant
Game
Fig ure 10. Mod ified Game with Id entical Normal
Form
Play," 2. The firm then infers that the
s ig naler is type 2, 3, or 4. Howev er, as
with the other qualitativ e criteria, s tabil-
ity places no res triction on the cond i-
tional probability that the s ig nal 2 was
s ent by type 2. In particular, we are
free to as s ig n a v ery low cond itional
probability. Giv en s uch beliefs , each
firm res pond s with a wag e offer too low
to be preferred by any of the types .
Then all cons ultant types are wors e off
choos ing the out-of-equilibrium s ig nal
2. It follows that the Nas h equilibrium
is s table. Ind eed all the Nas h equilibria
that s eparate type 1 from the other
three types are "s table."
S uppos e ins tead that Bayes ' Rule is
us ed to upd ate beliefs . Then, in re-
s pons e to the d ev iation to 2, the wag e
offered to types 2, 3, and 4 will be bid
up to their expected marg inal prod uct
V234. If this is the cas e, types 2-4 ind eed
hav e an incentiv e to d ev iate. As in the
two-type cas e, only the Pareto d ominat-
ing equilibrium that s eparates out type
1 s urv iv es .
Of cours e, as illus trated in s ection 2,
we knowthat s uch Gros s man-Perry up-
d ating of beliefs can lead to nonexis -
tence. The example makes clear how
d ifficult it is to find a refinement of
Nas h equilibrium that has enoug h bite
to rule out a continuum of equilibria,
without als o creating an exis tence prob-
lem. To me, the s imples t way out of the
maze is to employ the s trong er Gros s -
man-Perry approach and then s eek con-
d itions that are s ufficient to ens ure ex-
is tence. 16 If there is an equilibrium
that s atis fies the s trong er criterion, it is
the Pareto d ominating s eparating equi-
librium. As I hav e emphas ized , the
critical requirement is that, for the s ig -
nals chos en in this Nas h equilibrium,
the marg inal cos t of s ig naling s hould
d ecline s ufficiently rapid ly with type.
4. Ind us trial Org anization
There has been a remarkably rich s et
of applications of s ig naling in the ind us -
trial org anization field . In many cas es ,
papers are not s imply s traig htforward
applications , but hav e ad v anced the
theory s ig nificantly. The earlies t litera-
ture focus es on the role of ad v ertis ing
as a s ig nal of prod uct quality. Phillip
Nels on (1974) contras ts ad v ertis ing of
g ood s that mus t be cons umed before
they can be fully appreciated with g ood s
that can be ev aluated in the s hop. He
conclud es that ad v ertis ing of "experi-
ence g ood s " is much more focus s ed on
attracting attention to the brand than
prov id ing information about prod uct
quality. While he d id not attempt a formal
mod el, he arg ues that hig h ad v ertis ing
expend itures on brand s are s een by
cons umers as a s ig nal of prod uct quality.
Benjamin Klein and Keith Leffler
(1981) and Paul Milg rom and John
Roberts (1986) build clos ely related
mod els of repeat purchas ing that yield
Nels on's conjectures . To illus trate the
16
For a contrary v iew s ee Mailath, Mas ahiro
Okuno-Fujiwara, and And rewPos tlewaite (1993),
who arg ue that if an out-of-equilibrium action is
obs erv ed , the rev is ed beliefs s hould be fully
cons is tent with s ome other equilibrium. Pos itiv e
probability is as s ig ned
only
to t os e types who are
better off in the alternativ e equilibrium. The
Pareto d ominant Nas h s ig naling equilibrium is
then the unique "und efeated " equilibrium.
central is s ues , we will cons id er a
s tripped -d own v ers ion of the Milg rom-
Roberts mod el. S uppos e there are two
quality lev els , hig h and low. In a world
of full information, the firm would s ell
to one g roup of cus tomers when it had a
hig h-quality prod uct (at a hig h price)
and another g roup when its prod uct was
of lowquality. Each potential cus tomer
buys at mos t one unit per period . Thus ,
in the hig h-end market, with d emand
price function pH(q), the quantity q is
the number of hig h-end cus tomers .
S imilarly in the low-end market, if the
price is s et at pL(q), the quantity q is the
number of low-end cus tomers . S uppos e
that in period one, buyers d o not know
quality. Howev er, if ad v ertis ing is s uffi-
ciently intens iv e, then they will infer
that quality is hig h. After period one,
information on ad v ertis ing is forg otten,
but all thos e who hav e purchas ed know
prod uct quality. Thus , if and only if
quality is ind eed hig h, the firm will
maintain its hig h-end cus tomer bas e. As
a res ult, there is a payoff to s ig naling in
the s hort- and long -run for a firm with a
hig h-quality prod uct. A low-quality pro-
d ucer makes a s hort-run killing if he
mimics but mus t lower his price on all
repeat s ales after period one, when
quality is known.
Let r be the interes t rate and as s ume
an infinite horizon. If the firm is be-
liev ed to be s elling a low-quality prod -
uct, the pres ent v alue of its profit
s tream is the firs t-period profit plus the
d is counted future s tream of profits
UL(qL)
=
rL(qL) +- L(qL),
where
qL
is
chos en to maximize profit RL(q)
- CLq.
If the hig h-quality firm choos es price
pH(q) and ad v ertis ing expend itures A,
which is hig h enoug h to s ig nal hig h
quality, the pres ent v alue of its profit
s tream is UH(q,A)
= IFH(q)-A + -IlH(q)=
H
+r[H(q) -A. Giv en beliefs about the
s ig nal conv eyed by the ad v ertis ing , a low-
quality firm can fool hig h-quality cus -
tomers by mimicking in period 1. That
is , it can als o choos e A and the intro-
d uctory price
PH(q).
If it d oes , it has a
pres ent v alue of
UM(q,qL,A)
=
rlM(q)
- A +
rHL(qL)
1 (5)
-HH(q) + (CH - CL)q-A + -lL(qL).
Ir
The low-quality firm thus prefers to
mimic if, for s ome (q,A),UM(q,qL,A)
? UL.
As s uming d iminis hing marg inal rev enue,
this reg ion mus t be as d epicted in fig ure
11. Als o d epicted is an ind ifference
curv e UH(q,A) = UH for s ome hig h-quality
firm. S ince the pres ent v alue of the firm
is linear in A, all the hig h-quality ind if-
ference curv es are v ertically parallel with
turning points at the profit maximizing
output lev el qi. Moreov er, from (5), as
long as the lower-quality firm has lower
cos ts , it mus t be the cas e that qH <
q-.
It
follows from the fig ure that the profit-
maximizing s eparating point is (qs ,As ).l7
Note that the s ig naling quantity is s et
lower than the monopoly output und er
fuRl information. Thus , the introd uctory price
s et by the monopoly with a hig h-quality
prod uct is abov e the full-information
monopoly price.
This arg ument is extend ed by Birg er
Wernerfelt (1988), who arg ues that
firms may often be able to s ig nal quality
more cheaply by build ing a reputation
for a rang e of prod ucts all benefiting
from the "umbrella" reputation of the
firm its elf. That is , ins tead of ad v ertis -
ing prod uct by prod uct, there are
economies of s cale in brand ing a g roup
of prod ucts as all belong ing to the s ame
part of the quality s pectrum.
All thes e mod els focus on the oppor-
tunity for s ig naling by a s ing le firm in
ord er to exploit its monopoly power
17All points outs id e the s had ed reg ion, which
g enerate a non-neg ativ e payoff, are Nas h s ig naling
equilibria. Applying the s tand ard refinements
yield s the unique equilibrium S .
A
ad v ertis ing
S ~~~~~
Fig ure 11.
Ad v ertis ing
as a
S ig nal
of Prod uct
Quality
und er imperfect information. Richard
Kihls trom and Michael Riord an (1984)
s how that if firms are price takers ,
there can be no s uch equilibrium with
ad v ertis ing . Firms g et zero profits if
they are s eparated , thus it is always ad -
v antag eous for a low-quality firm to
mimic ov er the initial "experience" period .
A clos ely related line of res earch ex-
plores cond itions und er which a hig h
introd uctory price can alone be a s ig nal
of prod uct quality. For this to be the
cas e, there mus t be s ome heterog eneity
in the ability of cons umers to d is tin-
g uis h quality prior to purchas e. Kyle
Bag well and Riord an (1991) as s ume
that s ome cons umers hav e full informa-
tion while others know only the prior
(exog enous ) d is tribution of prod uct
quality. Let pH(q) be the d emand price
function when it is believ ed that quality
is hig h. Let CL and CH > CL be the unit
cos ts of a low- and hig h-quality firm.
Then the profit of a firm of quality lev el
t is
Ht(q)
=
pt(q)(q
-
ct),t
=
L,H.
We as -
s ume that, for each type, marg inal
rev enue is d ecreas ing s o that the profit
function is s trictly concav e with a s ing le
turning point at q*. Then maximized
profit is JX = pt(q*)(q* - Ct). If a low-cos t
firm can trick all cons umers into believ -
ing it is s elling a hig h-quality prod uct, it
faces a d emand price pH(q) and thus has
a profit of
nH
(q)
=
pH(q)(q
-
CL) (6)
=
HH(q)
+
(CH
-
CL)q.
S uppos e next that a fractionf of the con-
s umers are informed and s o d o not pur-
chas e when a low-quality firm mimics
the hig h-quality firm by announcing an
introd uctory price p(q). The profit of the
mimicking firm is then red uced to
(1
-fj)lH(q).
Nowit pays to mimic if and
only if
ffLm(q)
> L
(7)
1 -f
S ince the unit cos t of prod uction is lower
for the mimicking firm, rlm(q) has a
unique turning point at qm > qi. It
Profit
VH(Z )-CH (Z=)
/
H~~~~~~~~~~~~~L-
=
H (Z-L
(Z)
nL~~~~~~~~~~~~~~~~~~~~~~V XZ
cL
(z!
z
Z* z
z
s
Warranty
FL g H H
Fig ure
12.
Warranty
as a
S ig nal
follows that there is a unique pair of
quantities q' and q", where q' <qm <q",
s uch that (7) hold s only for quantities in
the interv al q',q".
If the profit-maximizing quantity for
the hig h-quality firm is les s than q',
there is no incentiv e to mimic. S epara-
tion is thus achiev ed at no cos t. On the
other hand , if qi > q', the leas t cos tly
s eXarating
price is either q' or q". But
HIL(q') = Lm(q). It follows immed iately
from (6) that HH(q') > HH(q"). Hence the
leas t cos tly means of av oid ing mimick-
ing is for the hig h-quality firm to
choos e the quantity q'. That is , it s ets an
introd uctory price p(q') > p(qH).
Another line of res earch explores the
role of warranties as s ig nals of prod uct
quality. The earlies t papers by S pence
(1977a) and Gros s man (1981) us e many
of the id eas from the s ig naling literature
but are really ris k-s pread ing s tories . In
each cas e firms s ell items of uncertain
quality to ris k-av ers e ind iv id uals . Firms
are as s umed to be ris k neutral, thus an
efficient contract with buyers inv olv es
full cov erag e.
A s imple s ig naling explanation for
warranties is bas ed on prod uct d urabil-
ity (Es ther Gal-Or 1989). S uppos e that
a monopolis t prov id es a warranty that
offers to repair any d efects until ag e z.
Let Vt(z) t E {L,H} be the expected v alue
of the prod uct to cons umers if the
warranty lev el is z. Let Ct(z) be the ex-
pected unit cos t of prod ucing the g ood
and prov id ing s uch a warranty. The ex-
pected payoff to a cons umer if the
monopolis t charg es a price P is then
Ut(z,P)
= Vt(z) - P. With complete in-
formation about the firm's type, the
monopoly s olution is d epicted in fig ure
12. The firm extracts all of the s urplus
s o that the profit Ht(z)
= Vt(z)
-
Ct(z) is
maximized by s etting a warranty lev el Zt*
and price P*= Vt(z*). But if buyers d o
not obs erv e quality, a low-quality firm
can mimic and charg e a price P
=
VH(Z).
The profit of the low-quality firm is then
HrL(Z)
=
VH(Z)
-
CL(Z).
In the
fig ure, Hrl(zL)
exceed s the full information profit,
s o mimicking is profitable. The hig h-
quality firm then mus t increas e its war-
ranty lev el to zs in ord er to eliminate
the incentiv e to mimic.
Nancy Lutz (1989) prov id es an alter-
nativ e d es cription of s ig naling in a
S pence/Gros s man ins urance mod el of
warranties . Cons umers exhibit moral
hazard in taking care of the prod uct,
thus ins urance cov erag e is only partial.
As in the mod el abov e, the cos ts of pro-
v id ing this partial cov erag e are hig her
for a low-quality firm, thus the extent of
the warranty is ag ain a potential s ig nal.
Des pite the plethora of theories arg u-
ing that introd uctory prices , ad v ertis -
ing , and warranties can s ig nal hig h qual-
ity, there is remarkably little applied
work s eeking empirical s upport. More-
ov er, the papers that d o attempt to look
at the d ata d raw mixed conclus ions .
Gers tner (1985) examines the relation-
s hip between price and quality us ing
d ata from the Cons umers Union Buying
Guid e. Us ing the Guid e's quality rank-
ing as a proxy for quality, Gers tner find s
only weak s upport for the hypothes is
that hig her quality is correlated with
hig her price. C. Hjorth-And ers en (1991)
extend s this analys is by introd ucing a
v ector of quality ind icators and leav ing
the d ata to s peak for its elf on the nature
of the ov erall connection between thes e
ind icators and prod uct price. His tes t is
whether there is a pos itiv e relations hip
between the d ifferent quality ranking s .
Us ing both Cons umer Reports d ata and
Danis h d ata, he ag ain conclud es that
there is at bes t only a weak link be-
tween quality and price. He als o cons id -
ers Wernerfelt's arg ument about um-
brella brand ing and find s only a v ery weak
correlation of quality ind icators acros s
d ifferent prod ucts prod uced by the
s ame firm. While thes e res ults are a
challeng e to the theory, it s hould be
noted that neither d irectly ad d res s the
point of the theoretical papers which is
primarily that firms will s eek to s ig nal
quality when introd ucing newexperience
g ood s .
Jos hua Wiener (1985) us es Cons umer
Reports d ata on automobiles to s ee
whether hig her priced cars hav e better
warranties . He find s that ind eed there
is a s trong pos itiv e correlation, lend ing
s upport to the id ea that warranties d o
s ig nal quality. Finally, Daniel Ackerberg
(1996) pres ents s tructural and red uced -
form es timates of a d ynamic learning
mod el. One of the central ques tions he
as ks is whether the effect of ad v ertis ing
a newprod uct primarily s ig nals quality
(a "pers uas iv e" effect) or primarily pro-
v id es information about the prod uct.
For the particular prod uct s tud ied (the
introd uction of a new yog urt) he is
unable to find a s ig nificant pers uas iv e
effect. This paper is a v aluable firs t s tep
in what s eems to be a field ripe for d e-
tailed empirical inv es tig ation, es pecially
as firms beg in to s eek ways to exploit
the v as t amounts of s ales d ata s tored
electronically.
4.1 Limit Pricing
Another area in which s ig naling mod -
els hav e been central is in the analys is
of entry. Cons id er the cas e of a monop-
olis t who faces a potential entrant. One
important s ource of informational as ym-
metry is that each firm is likely to be
uncertain about the unit cos t of its
potential competitor. Giv en this infor-
mational as ymmetry, mig ht an incum-
bent profitably d eter entry by s etting a
"limit price" rather than the monopoly
price prior to entry? As Milg rom and
Roberts (1982) s howed , this may ind eed
be the cas e. To illus trate the is s ues ,
cons id er a s imple two-period mod el. In
the firs t period , the incumbent with
unit cos t ci is the only firm in the
market. The entrant, with unit cos t CE,
obs erv es the firs t-period price and then
makes an irrev ocable d ecis ion whether
or not to enter. In period 2, if there is
entry, the res ulting competition yield s a
d uopoly profit to the incumbent of
H1(cL,cE). In the abs ence of entry, the
incumbent s ets the monopoly price in
period 2 and his profit is fl*(ci). In the
firs t period his profit is q(p)(p - ci).
S uppos e that the entrant's cos t is c or
les s with probability FE(C). If all en-
trants with cos ts hig her than c are s uc-
ces s fully d is courag ed from entering , the
incumbent's profit is
U(p,y,ci)
=
q(p)(p
-
c1)
+
(1
-
FE(Z))f*(C1)
c
+
JI`1(Cl,CE)d FE(CE)
0
The ques tion is whether the incumbent
encourag es more firms to s tay out by
s etting a lower "limit price" in the firs t
period . Formally, is it pos s ible to charac-
terize a mapping cs (p), from the incum-
bent's price to the cos t of the marg inal
entrant, s uch that the lower the equilib-
rium price, the lower is the cos t of the
marg inal entrant? If this is the cas e, in-
cumbents will be s eparated . Thus , the
critical entrant has a cos t c, s atis fying
HE(cl,c) = 0. The pairs (c,z) s atis fying
this cond ition are d epicted in the left
half of fig ure 13. Whether or not types
are s eparated hing es on whether an in-
cumbent with a hig her cos t has a s teeper
ind ifference map. That is , for a s eparat-
ing equilibrium, we require that the
s ing le-cros s ing property be s atis fied .
Mathematically we require that
aul
d c - __
ap
d p _aul
ac
increas es with the incumbent's cos t.
While this is not automatically s atis fied ,
it is eas y to find cas es where the s ing le-
cros s ing property hold s . Therefore "limit
pricing " can s ig nal an incumbent's
toug hnes s .
One of the points emphas ized by Mil-
g rom and Roberts is that in a s eparating
equilibrium the types of firms that d o
enter are exactly thos e that would enter
if the entrant could d irectly obs erv e the
incumbent's type. Thus , limit pricing
d oes not d is courag e entry relativ e to a
world of full information. Ins tead , limit
pricing is a mechanis m the incumbent
us es to d is courag e entry of thos e firms
that would otherwis e enter becaus e of
as ymmetric information.
One as s umption of the Milg rom-
Roberts mod el is that the cos t of the
potential entrant is uncorrelated with
the cos t of the incumbent. Jos eph Har-
ring ton (1986) extend s the analys is to
the cas e of correlated cos ts . S uppos e
that only after he enters will the entrant
know his cos t with certainty. If cos ts are
pos itiv ely correlated , information about
the incumbent's cos t will affect the en-
try d ecis ion. The incumbent thus has an
incentiv e to s ig nal that his cos t is hig h
and thereby d is courag e entry. Har-
ring ton s hows that if cos ts are s uffi-
ciently hig hly correlated , the optimal
s trateg y of the firm is to choos e a price
hig her than the monopoly price,
thereby s ig naling that his cos t is hig h.
In a further follow-up paper, Bag well
and Garey Ramey (1988) cons id er the
further implications if ad v ertis ing has a
d irect effect on d emand . They s how
that it is efficient for the incumbent to
combine the limit pricing s trateg y with
a s econd s ig nal-ad v ertis ing beyond the
lev el that would prev ail in the abs ence
of the informational s ymmetry.
Roberts (1986) offers a mod el v ery
s imilar in s pirit to explain the "pred a-
tory pricing " of an incumbent firm. The
informational s tructure of the mod el is
the s ame. Here, thoug h, the entrant
mov es firs t, choos ing whether to enter.
CI
cos t of marg inal entrant
nE (Cl,
c) 0 cs (p)
...............................................................U
-1
(p ,
CI,
CE)
=
U1
C
.
incumbent's cos t price s et by incumbent
Fig ure 13. Limit Price S ig naling
If it d oes , the incumbent and entrant
compete for one period . The entrant
mus t d ecid e whether to continue or to
withd rawand leav e the market to the
incumbent in period 2. Ag ain it is not
too d ifficult to build a mod el in which
the opportunity cos t of flood ing the
market in the firs t period (and d riv ing
price d own) is lower for a toug her in-
cumbent. Thus , the res ulting period 1
price is a s ig nal of the incumbent's
toug hnes s .18
Drew Fud enberg and Jean Tirole
(1986) offer an alternativ e explanation
of pred ation by an incumbent firm. In
their mod el, the entrant is uncertain
about howcos tly it will be to operate in
the market. It als o d oes not obs erv e the
choice of the incumbent.19 Let s i and S E
be the s trateg ies of the incumbent and
entrant. In the firs t period , the entrant
obs erv es its profit and then us es its own
profit UE(s 1,s E) to make an inference
about its total cos t & = C(rIE(S 1,S E),S E).
S ince the incumbent's s trateg y is not
obs erv able, his s trateg y has a d irect ef-
fect on his own profit and an informa-
tional effect on his opponent's inference.
This g iv es the incumbent an incentiv e
to lower price. Note that the entrant is
not fooled s ince he can infer the incum-
bent's equilibrium s trateg y. It is s imply
the non-obs erv ability of the s trateg y
that increas es the incentiv e to lower price.
Of cours e, to the extent that the entrant
is uncertain about the incumbent's cos t,
this "s ig nal-jamming " effect and the
s ig naling effect are reinforcing .20
LeBlanc (1992) has s hown that by
ad d ing s lig htly to the d ynamic s tructure
of thes e g ames , both limit pricing and
pred atory pricing can emerg e as equi-
librium s ig nals . In the initial round the
18
If the incumbent faces an infinite s equence of
potential entrants , fairly s tand ard "folk theorem"
arg uments s howthat there is an equilibrium in
which weaker incumbents mimic the s trong es t
incumbent in res pond ing to entry. As Milg rom
and Roberts (1982) and Kreps and Wils on (1982b)
s how, mimicking remains equilibrium behav ior in
the initial period s ev en if there is a long finite
horizon.
19This could be the quantity s old or the s ecret
d is count on the lis ted price offered to "loyal"
cus tomers .
20
Kirman and Mas s on (1986) cons id er the role
of capacity s ig nals as a d eterrent of entry. In their
paper the entrant is uncertain about the d eg ree
to which the incumbent olig opolis ts operate as a
cartel and res pond collus iv ely.
limit pricing conv eys s treng th. It is us ed
if the incumbent is v ery s trong and the
prior belief is that this is v ery unlikely.
Howev er, if the prior belief is that the
incumbent is likely to be s trong and
the entrant is likely to be weak, then
the incumbent would prefer only to s ig -
nal his s treng th in the unlikely ev ent
that the entry actually takes place. In
this s ituation, there is pred atory pricing
rather than limit pricing .
While I am not aware of a paper that
formally mod els the capacity d ecis ion of
the entrant as a s ig nal of s treng th (low
unit cos t), it is intuitiv ely clear that s uch
a mod el could be eas ily d ev eloped along
the lines of the limit pricing mod el.
While the timing is d ifferent, s uch a
mod el would s eem to flownaturally from
the earlier work on equilibrium conjec-
tures by potential entrants . Build ing s uch
a mod el would be us eful as a part of an
ev aluation of the relativ e efficiency of
d ifferent method s of s ig naling s treng th.
One paper, which d oes focus on
capacity s ig nals , prov id es a rare analys is
of entry when the incumbents are mem-
bers of an olig opoly rather then a mo-
nopoly. (This is another area crying out
for further s tud y.) William Kirman and
Robert Mas s on (1986) cons id er a mod el
in which the entrant is uncertain about
the d eg ree to which the incumbent oli-
g opolis ts operate as a cartel and then
res pond collus iv ely. In the mod el the
weak olig opoly res pond s with a round of
competitiv e price cuts . S uch behav ior
d is courag es entry. Thus the collus iv e
olig opoly has an interes t in mimicking
the weak olig opoly. This it can d o by
ad d ing enoug h capacity to s imulate the
weak olig opoly outcome.
Mailath (1989) d oes cons id er s imulta-
neous s ig naling among olig opolis ts . His
focus is not on d eterrence per s e, but
on the effects of each firm d rawing
inferences about its opponents ' cos ts .
Cons id er two firms s elling a d ifferenti-
ated prod uct. In period 1 neither knows
its opponent's cos t. Thus a naiv e choice
would be to maximize firs t-period ex-
pected profit. If firm B's s trateg y is to
s et a price p B(CB), the naiv e bes t re-
s pons e of firm A is to choos e pA(CA) to
s olv e Max E{nI (pI,pIl(jB),CA)}. Howev er, the
firs t-period d ecis ion will be us ed by
firm B to d rawan inference about firm
A's actual cos t. As s uming that the equi-
librium is monotonic, firm B can inv ert
and infer that cA =
cA(pA). Let pB(CA,CB)
be firm B's equilibrium price in pe-
riod 2, g iv en full information. Then if
firm A choos es a firs t-period price of
p1,
its total
profit
is
E{HA(pA,pB(CB),cA)
+
2 2
,p2 (c I . S ince the choice
of firm A's firs t-period price s ig nals its
unit cos t, there is an informational ef-
fect that the firm mus t take into ac-
count in ord er to maximize profit. In
s tand ard d ifferentiated d uopoly mod els ,
firm B res pond s to a hig her cos t by rais -
ing its price, recog nizing that firm A
will als o price hig her. Thus firm A has
an incentiv e to pus h up its firs t-period
price, which ind uces a hig her s econd -
period price for firm B. In equilibrium,
neither firm is fooled . Howev er, the in-
centiv e that res ults from information being
s ig naled lead s to hig her firs t-period
prices 21
Finally, two papers cons id er the en-
d og enous timing of d ecis ions . Mailath
(1993) cons id ers a Cournot g ame in
which the firm with les s information
about d emand mov es in period 2. The
better-informed firm can choos e period
1 or period 3. If it lead s , then its choice
s ig nals its information to its opponent.
Des pite this , at leas t in the mod el con-
s id ered , the unique equilibrium s atis fy-
ing plaus ible refinements has the in-
formed firm mov ing firs t. And rew
Daug hety and Jennifer Reing anum
21
As Mailath notes , there are exis tence and
uniquenes s is s ues that are non-triv ial in olig opoly
mod els .
(1994) take this a s tep further and allow
firms to choos e whether to acquire in-
formation. In equilibrium, a firm knows
whether its opponent is informed and
thus how much information is conv eyed
by its future d ecis ions . An ag ent mus t
then d ecid e whether and when to s eek
information, knowing that this choice
will influence the nature of the s ig nal-
ing g ame. The g ame its elf is therefore
d etermined end og enous ly. As in s tand ard
s ig naling mod els , the intuitiv e criterion
is employed to obtain a unique s eparat-
ing equilibrium in each pos s ible realiza-
tion of the information acquis ition g ame.
In the d uopoly prod uction g ame ana-
lyzed in the paper, the two players are
ex ante id entical. For certain parameter
v alues , howev er, the information acqui-
s ition phas e of the g ame has only as ym-
metric equilibria. Thus , as ymmetry is
end og enous ly ind uced and a s ig naling
g ame is then played out. The players als o
choos e whether to act s imultaneous ly or
s equentially (lead er-follower.)
The mod el is illus trativ e rather than
conclus iv e. Howev er, is s ues of timing
are important, and making them a part
of the s olution rather than impos ing
timing as s umptions is another fruitful
av enue for further res earch.
5. Labor
As in ind us trial org anization, the ba-
s ic theory has been us ed to explain a
wid e rang e of theoretical puzzles . How-
ev er, there is cons id erably more empha-
s is on empirical v erification. Rather than
attempt to cov er ev erything , this s ection
focus es primarily on three areas which
hav e attracted cons id erable interes t. The
firs t s eries of papers attempts to tes t
S pence's ed ucational s creening hy-
pothes is ag ains t the trad itional human
capital explanation of ed ucational choice.
The s econd g roup examines the impli-
cations for promotion when outs id ers
(other firms ) us e this as a s ig nal of in-
formation learned on the job by the cur-
rent employer. The third g roup of papers
looks at labor-manag ement contract
is s ues .
5.1 Ed ucational S creening
Both the human capital mod el and
the s creening mod el imply that earning s
s hould increas e with ed ucation. Thus
s imply es timating an earning s function
is not likely to s hed much lig ht on the
s creening role of ed ucation. Let z be an
ind iv id ual's ed ucational achiev ement.
Let 0 be an unobs erv ed v ariable repre-
s enting the ind iv id ual's ability. S uppos e
an ind iv id ual of type 0 and ed ucation
lev el z has a marg inal prod uct of
v = V(O,z) + e, where ? is a realization of
the ind epend ent rand om v ariable E
which has a zero mean. The cos t of
achiev ing ed ucation lev el z is C(0,z). In
the human capital s tory, informational
problems are of s econd ord er. A type 0
ind iv id ual choos es z*(0) to maximize his
net payoff U(0,z,w) = w - C(0,z), where
w = V(0,z) + c. Und er weak as s ump-
tions , the choice z*(0) is monotonic. In-
v erting this , we may write 0 = 0*(z). He
then earns a wag e of w = V(0*(z),z) + c.
The obs erv ed d is tribution of wag es is thus
i(z)
= V(O*(z),z) + E. (8)
As d is cus s ed in s ection 2, firms that
d o not obs erv e marg inal prod uct (in the
early years on the job) will pay a wag e
bas ed on ed ucational cred entials . A type
0 ind iv id ual s olv es Max{w(z) -
C(O,z)l.
In
a s creening equilibrium, hig her types
choos e more ed ucation. Inv erting , there
is a monotonic relations hip between ed u-
cation and the unobs erv ed ability Os (z).
Firms bid wag es up to expected mar-
g inal prod uctiv ity s o that the expected
wag e is
ws (z)
=
E{V(Os (z),z) + @
=
V(Os (z),z). (9)
Early empirical work (e.g ., Paul
Taubman and Terence Wales 1973) was
hampered by the abs ence of an equilib-
rium mod el of s creening . S ince
S pence's papers , much of the empirical
work s tarts with the as s umption that
s creening is more important in s ome
s ectors than in others . Richard Layard and
Georg e Ps acharopoulos (1974) compare
earning s functions of s tud ents who
achiev e s ome ed ucational cred ential
(s ay a bachelor of arts d eg ree) with
thos e who d o not. They arg ue that the
cred ential s hould hav e s trong explana-
tory power only in a s creening world .
For the d ata that they cons id er, there is
no s uch s trong effect. While, on its
face, this is ev id ence ag ains t ed uca-
tional s creening , the d ata is far from
id eal. The s ample is a s et of World War
II v eterans who were g etting a d eferred
ed ucation in a booming job market.
Pres umably many were "pulled " from
ed ucation rather than d ropped out.
Thomas Hung erford and Gary S olon
(1987) us e Current Population S urv ey
(CPS ) d ata to further tes t the "s heep-
s kin effect." They find a s ig nificant
pos itiv e effect as implied by s creening
theory. John Heywood (1994) analyzes
ad d itional CPS d ata and ag ain find s a
s ig nificant s heeps kin effect. Howev er,
this effect is s ig nificant only in the priv ate
non-union s ector and not els ewhere. It
is far from clear that a s creening s tory
can be eas ily cons tructed to explain the
abs ence of s creening in other s ectors .
A s erious problem with thes e s tud ies
is that they d o not s pell out which v ari-
ant of the trad itional human capital
mod el or s creening mod el is to be
tes ted . In the human capital mod el, the
prod uctiv ity of a colleg e g rad uate is a
function of what he has learned at col-
leg e. This is pos itiv ely related to his
g rad es and the quality of the colleg e
that he attend s . Pres umably, thos e who
d rop out d o s o becaus e they find the
g oing toug h and their g rad es are low.
Thus , the prod uctiv ity of the d ropouts
is lower than that of a repres entativ e in-
d iv id ual from the clas s . When income is
reg res s ed ag ains t years of colleg e ed u-
cation plus a "s heeps kin" d ummy, the
latter picks up the d ifference in the rate
of capital accumulation among d rop-
outs and the res t of the clas s . There-
fore, if d ata on d ropouts are to be us ed
as ev id ence, one neces s ary preliminary
s tep is to prov id e a theory of why s ome
s tud ents d rop out.
Of all the empirical work that build s
on the theory, the mos t creativ e is by
Kev in Lang and Dav id Crop (1986). To
illus trate their central point, cons id er
the following s pecial cas e of the s creen-
ing mod el d es cribed abov e. The mar-
g inal prod uct of a type 0 ind iv id ual who
achiev es an ed ucation lev el z is V(0,z) =
Oz, while his cos t of ed ucation is
C(0,z) = 2z2/0. S uppos e that ev ery type
has the s ame outs id e opportunity to
earn a wag e r with no colleg e ed uca-
tion. With full information, type 0 is
paid a wag e equal to his marg inal prod -
uct. He therefore choos es an ed ucation
lev el z*(0) = arg Max{0z - 2z2/0}. It is read -
ily confirmed that z*(0) = 02, and hence
that his net payoff is U*(O)= -03. S ince
all types can earn r in another ind us try,
the lowes t type, Oo, who enters the in-
d us try is jus t ind ifferent between d oing
s o and earning r. Thus
U*(00)
= 03 = r
and hence 00 = (2r)3. It follows that the
minimum ed ucation lev el and wag e is
(z,w)
=
((2'r)32,2r).
(10)
For all hig her types , the wag e of type 0
is W*(0)
=
V(O,z*(0))
= 03. Then, s ince
z*(0) = 02, the obs erv ed "wag e function"
is
W*(Z)
=
Z2, Z >
zo(r)' lt
Next cons id er a s creening equilib-
rium. From s ection 2 we knowthat the
outcome is exactly the s ame for the low-
es t type who choos es a colleg e ed uca-
tion. That is , (zo,wo) s atis fies cond ition
(10). Giv en a wag e function w(z), each
hig her type choos es zs (O) to s olv e
Max{w(Z) - 'z2/0}. It is read ily confirmed
that the firs t-ord er cond ition is
w'(z) = z/O. In equilibrium, each type has
a wag e equal to his marg inal prod uct,
thus w= Oz. Combining thes e two con-
d itions yield s the d ifferential equation,
w(z)w'(z) = z2, with end -point cond ition
(10). Direct integ ration and s ubs titution
yield s the s creening equilibrium wag e
function
w2(z)
-
+ o z 2z0,z2z0(r), (12)
where wo = 2r.
The important thing to note is that
while a chang e in the outs id e opportu-
nity affects the minimum entry lev el, it
d oes not affect wag es for hig her types
in the full-information world . Howev er,
in the s creening equilibrium, the entire
wag e function ris es with an increas e
in the outs id e wag e. The intuition is
relativ ely s traig htforward . With the im-
prov ed outs id e opportunity, the mini-
mum type to enter colleg e is g reater
than before. Therefore, the neces s ity
for a type to s ig nal that he is better than
all lower types in the market is red uced .
As a res ult, ov er-inv es tment in ed uca-
tion falls and ev eryone is mad e better
off. This can only be achiev ed by a ris e
in the equilibrium wag e function.
Effectiv ely, the s ame arg ument ap-
plies when the mand ated minimum
ed ucational cred ential is increas ed .
Lang and Crop look at the effects of
chang es in compuls ory attend ance laws .
They conclud e that there is a s ig nificant
"ripple effect" as pred icted by the
s creening mod el.
Another approach, which build s on
the theory, beg ins with the obs erv ation
that s creening will be mos t important in
thos e s ectors where prod uctiv ity is rela-
tiv ely hard to meas ure. In Riley (1979a)
the key as s umption is that the d ifferent
s ectors are not s eg reg ated accord ing to
ability. Then a s ubs et of types mus t be
ind ifferent between working in the
"<s creened " and "uns creened " s ectors .
The only way this can occur is if, when
hold ing ability cons tant, jobs in the un-
s creened s ector inv olv e les s ed ucation.
In ad d ition, hold ing ed ucation cons tant,
wag es in the uns creened s ector are
hig her. This obs erv ation is then us ed to
s eparate jobs (as clas s ified in the CPS
d ata) into an "uns creened " g roup with
lowed ucation and abov e-av erag e wag es
and a s econd "s creened " g roup with hig h
ed ucation and below-av erag e wag es .
The tes t of the s creening hypothes is is
whether there are other d ifferences
between the two g roups , which can be
pred icted by s creening theory.
One crucial is s ue for potential tes ting
is how quickly firms beg in to id entify
true prod uctiv ity and s ubs equently ad -
jus t wag es to reflect this newinforma-
tion. In jobs where s creening is impor-
tant, one would expect the earning s
function to explain wag es v ery well
early in the life cycle. In the extreme
cas e, repres ented by the wag e function
in equation (9), ed ucation and wag e are
perfectly correlated in the s creened
s ector, whereas the correlation is
weaker in the uns creened s ector (s ee
equation 8).
If, in ad d ition, firms accumulate in-
formation about true prod uctiv ity ov er
the early years in the work force, the
explanatory power of ed ucation s hould
d ecline. Thus the ratio of unexplained
res id uals for the s creened g roup ov er
that for the "uns creened " g roup s hould
ris e ov er time. Riley obs erv es s uch an
effect.
Kenneth Wolpin (1981) als o takes the
two-s ector approach us ing the NBER-
Thornd ike d ata firs t us ed by Taubman
and Wales (1973) and then by Layard
and Ps charopoulos (1974). All the men
in this s ample were g iv en extens iv e
ability tes ts . If thes e tes ts are unbias ed
es timates of true ability, one can then
compare the ed ucation lev els of the two
g roups to s ee whether ability is lower
for d ropouts . Wolpin find s only s mall
ability d ifferences and therefore con-
clud es that the d ata prov id e little
s upport for s creening theory. Howev er,
as alread y noted , trad itional human
capital theory yield s precis ely the s ame
pred iction.
Eric Fried land and Rog er Little
(1981) us e National Long itud inal S ur-
v ey d ata to explore the d ifference be-
tween the s elf-employed and s alaried
workers . At leas t in this s ample, the
s elf-employed hav e hig her av erag e ed u-
cational achiev ement and incomes than
s alaried workers . The inference is that
this g roup is a hig h-ability g roup and
thus the tes ts that appeal to ov erlapping
ability lev els no long er apply. This s ug -
g es ts that new theoretical pred ictions
are neces s ary before the s elf-employed
can be us ed in tes ts for s creening .
Finally, Wim Groot and Hes s el Oos -
terbeek (1994) us e Dutch long itud inal
d ata to s ee what happens to s tud ents
who either s kip a year of s chool or are
held back and forced to repeat a year.
S creening theory would s urely expect
the former to be a pos itiv e and the lat-
ter a neg ativ e s ig nal. S ince thes e effects
are not obs erv ed in the d ata, the
authors conclud e that this is s trong ev i-
d ence ag ains t the s creening hypothes is .
Id eally one would like wag e d ata early
in the life cycle. Howev er, in the d ata
examined , there is a thirty-year g ap
between the early collection of s chool
d ata and wag e d ata. Thus the abs ence
of a s ig nificant effect may be s imply
d ue to ov erwhelming nois e. S till, this
d oes s eem a fruitful av enue for further
empirical inv es tig ation.
One criticis m of the ed ucational
s creening hypothes is is that if the main
role of (s ay) g rad uating with a hig her
GPA from UCLA is to conv ey informa-
tion about natural ability, there is no
reas on for firms to wait until g rad u-
ation. Firms can look ins tead at lower
d iv is ion g rad es and recruit from the
fres hman clas s ! Howev er, once s tud ents
und ers tand that the cos t of s ig naling
is only the cos t of g etting hig h g rad es
for a couple of quarters , the s ig naling
equilibrium collaps es .22
Nold eke and Eric v an Damme (1990)
examine this informal arg ument in a
s imple two-type mod el. Their key inno-
v ation is the as s umption that the labor
market is open continuous ly. S uppos e
one firm d oes s tart recruiting from the
fres hman clas s . As they note, it is a bes t
res pons e of other firms to immed iately
follow the lead er. If this res pons e is s uf-
ficiently rapid , there is no reas on for a
s tud ent to accept the firs t offer be-
caus e, by waiting a v ery s hort interv al,
he will g et a better offer. The "ins tanta-
neous reaction" thus s us tains the s tan-
d ard equilibrium. Nold eke and v an
Damme then cons id er a d is crete time
v ers ion of the mod el and s how that
there is a unique equilibrium. In the
limit, as the time between offers g ets
s maller, the equilibrium approaches the
"ins tantaneous reaction" equilibrium.
The problem with s uch an arg ument
is that ins tantaneous res pons es g reatly
red uce incentiv es to innov ate. In real-
ity, much of the incentiv e for chang e
comes from the inability of potential
competitors to react immed iately. Thus ,
it s eems to me that the Weis s critique
cannot be s o eas ily ov ercome. What one
would really like is a mod el in which
ed ucation is not s imply a cred ential but
als o ad d s to human capital. A more
complete mod el of the ed ucational pro-
ces s would s urely als o allow colleg es to
choos e how to bund le cours es into con-
centrations (d eg rees ). In this cas e, much
of the v alue of the ed ucation may lie in
22
S ee And rewWeis s (1983).
s uch concentrations . Then d ropping out
early mig ht be v ery cos tly.
5.2 Employment S tatus as a S ig nal
As workers g ain experience on the
job, their employers g ather information
about them. This information will typi-
cally be better than information av ail-
able to outs id ers . The employer can
therefore hold d own wag e increas es and
s o earn rents from abov e-av erag e qual-
ity workers . Howev er, if it becomes
neces s ary to promote hig h-quality expe-
rienced workers into hig her lev el jobs , the
promotion becomes a s ig nal to outs id ers .
In the firs t paper to explore this is -
s ue, Michael Wald man (1984) as s umes
that workers accumulate firm-s pecific
human capital on the job. With full in-
formation, an ind iv id ual is s witched
from job A to job B ("promoted ") if his
marg inal prod uct is hig her in job B.
Cons id er a worker of type 0 whos e pro-
d uctiv ity is the s ame in the two jobs .
With full information, firms would be
ind ifferent as to whether or not to
promote. With as ymmetric information,
outs id ers bid up the wag es of thos e
promoted to the av erag e prod uctiv ity of
this g roup. Thus the type 0 worker has
a prod uctiv ity below the equilibrium
wag e in job B. Hence he will not be
promoted . It follows that as ymmetric
information res ults in fewer workers
being promoted . In a s econd paper
(Wald man 1990), it is as s umed that
workers accumulate g eneral human
capital. Then, if an ind iv id ual is pro-
moted , outs id e firms hav e an incentiv e
to expend res ources to obtain a nois y
es timate of the employee's actual pro-
d uctiv ity. The promoted worker g ets a
s mall initial wag e increas e and then
outs id ers compete for his s erv ices in an
auction. Ag ain this has the effect of
rais ing the quality of ind iv id uals pro-
moted abov e that which would prev ail
with full information.
Dan Bernhard t and Dav id S coones
(1993) extend this arg ument, noting that
the current employer can d is courag e
the inv es tment in information-g athering
by offering an es pecially outs tand ing
worker a preemptiv e wag e. The wag e is
cred ible if it is s ufficiently hig h to be
unprofitable unles s offered only to thos e
v ery clos e to the top of the ability d is tri-
bution. As long as the s upport of thes e
abilities is s ufficiently s mall, it is not
profitable for outs id ers to incur the cos t
of pre-auction information g athering .
The authors find informal confirming
ev id ence in acad emic job markets ,
where promotion to tenure is a s trong
pos itiv e s ig nal of quality. Ev en thoug h
many cand id ates fail to g et tenure, ini-
tial s alary increas es of thos e achiev ing
tenure are typically in the mod es t to
mod erate rang e. S alaries s ev eral years
after promotion are then d etermined by
the s treng th of the auction. Les s com-
monly, exceptional faculty are g iv en larg e
rais es with tenure, thus d is courag ing
the opening of an auction.23
A clos ely related paper by Milg rom
and S haron Os ter (1987) contras ts the
promotion of d ifferent s kill lev els when
part of the population is "v is ible" (abil-
ity is recog nized ) and part is inv is ible
(ability known only to the current em-
ployer). In contras t to Wald man, a key
und erlying as s umption is that the mar-
ket obs erv es the actual ability of anyone
who is promoted . Ag ain the ques tion is
who among the ins id ers , if anyone, will
be promoted . It is s hown that the
hig her rents earned on unpromoted in-
s id ers lead s to promotion of intermed i-
ate quality workers rather than the mos t
able.
S imilar arg uments hav e been mad e
about the implications of the d ecis ion
23
While I certainly knowof univ ers ities where this
s tory has a ring of truth, it really would be helpful
to hav e s ome s erious empirical inv es tig ation of the
phenomenon.
to lay off workers . Robert Gibbons and
Lawrence Katz (1991) note that with
as ymmetric information, termination is
a neg ativ e s ig nal of worker quality when
the terminating firm is a v iable opera-
tion. This is not true if the entire firm is
clos ing d own. They then look at d ata
from the Dis placed Worker S upple-
ments to the Current Population S urv ey
and find s trong s upporting ev id ence.
Finally, Ching -to Ma and Weis s (1993)
us e a s ig naling arg ument to explain the
leng th of unemployment s pells . In their
mod el, a laid -off worker who accepts a
poor job is s end ing a s ufficiently neg a-
tiv e s ig nal about his prod uctiv ity that
relativ ely more able workers choos e to
be unemployed .
5.3 Barg aining
The equilibrium theory of barg aining
between two ag ents initiated by Ariel
Rubins tein (1982) has been fruitfully
applied to union manag ement neg otia-
tions . In the bas ic noncooperativ e bar-
g aining mod el, the two parties make
alternativ e offers . S uppos e the two
parties are barg aining ov er whether the
profits of V s hould be retained by the
firm or d is tributed to the workers as
wag es . The critical id ea is that if the
ag ent making the firs t offer (ag ent 1)
looks ahead to the next time he makes
an offer, he can reas on as follows : If my
equilibrium payoff is Ui and if I g et to
make an offer two period s from now, I
s hould be able to us e my equilibrium
s trateg y from then on and g et at leas t
Ui at that time. Dis counting back one
period , my opponent will realize that
in period 2, when he makes his firs t
counteroffer, I can command a d is -
counted payoff of 6Ui. Then the bes t he
can d o is as k for the remaining s urplus
U2
= V -
Ui. A s ymmetric arg ument
for ag ent 2 es tablis hes that Ui = V -
5U2. Combining thes e two res ults , the
equilibrium payoffs (d is counted to the
time of each ag ent's firs t offer) are
U1 = U2 =
1.
Finally, d is counting ag ent
2's firs t offer to the firs t period , the
equilibrium payoffs are
(Ul,U2)
=
8v
l2'
Note that the total g ains to the 'wo par-
ties s um to V. This can only be the cas e
if there is no time cos t throug h d e-
lay. Thus the equilibrium s trateg y is for
ag ent I to as k for a fraction
1
of the
total pie and for ag ent 2 to accept this
immed iately.
Explanations for the d elays obs erv ed
in barg aining typically introd uce a cen-
tral role for s orting . S uppos e that the
firm has priv ate information about the
profit lev el. In the "s creening " v er-
s ion,24 the union s tarts with hig h offers ,
knowing that if profits are hig h, the cos t
of d elay is hig h and s o the firm will be
willing to acced e. Each round that the
firm refus es the union's offer, the union
rev is es d ownward s its beliefs about the
profits of the firm. S uppos e that in
round t beliefs about the future round
imply an expected wag e bill (d is counted
to period t + 1) of wt+ 1. Giv en thes e be-
liefs , the firm will accept any wag e offer
wt s atis fying V -
wt ? 6(V - wt + 1). Re-
arrang ing , the firm will accept a wag e
s atis fying the cons traint
wi
<
(1
-
6)V+ Wt+1. (13)
This inequality is d epicted in fig ure 14
for v aluations of VH, VM, and VL. If there
is s orting , then by period 3, it is a com-
mon belief that the firm's profit lev el is
VL. Appealing
to Rubins tein's
res ult,
there is a unique equilibrium wag e offer
W3(VL). Nowcons id er a firm with profit
VM. Giv en this
period
3
wag e,
the firm
will accept any period 2 wag e s atis fying
(13). Thus the bes t period 2 offer by the
workers is W2(VM) where the cons traint is
jus t s atis fied . The firs t period wag e offer
is s imilarly computed . Whether or not
24
S ee, for example Gros s man and Perry
(1986a), and S obel and Ichiro Takahas hi (1983).
wt
450 line
o
~~Wt
=
1-)VH
+
&Vt +1
t (V
H
)
.................._ ;;;.....
.....................
,
.
~~~~~~~~~~~wt
(I
(-
)VM
+
&Vt
I
t+1
w3(VL) w2(VM)
WI(VH)
wag e
inround t+
Fig ure
14.
Equilibrium S orting
Offers
full s orting of the three types is optimal
d epend s upon the d ifference between
the profit lev els and the likelihood of
each. For example, if VM and VL are s uf-
ficiently clos e, it is more profitable to
s imply s eparate out a hig h-profit firm.
One theoretical d ifficulty with this
mod el is that it d oes not explain the d e-
lay if the time between round s is s mall.
Ind eed , as Faruk Gull, Hug o S onnen-
s chein, and Wils on (1986) s how, in the
limit, as the time between barg aining
round s g oes to zero, there is no d elay.25
The s ig naling v ers ion of the mod el by
Anat Ad mati and Perry (1987) als o has
alternating offers , but each ag ent can
choos e how long to wait before pres ent-
ing his offer. S uppos e that the union
makes the firs t offer. Ag ain, the fact
that a more profitable firm los es more
by d elaying allows for s eparation. S up-
pos e that the firm has either a hig h-
profit VH or a low-profit VL. If the firm
d oes not d elay its counter-offer, the
union believ es that the profit is hig h.
Appealing to Rubins tein's theorem, the
union (the ag ent making the firs t mov e)
will then accept a wag e equal to
W(O) = 1 VH. If in fact the profit is low,
the firm d elays until time z before pre-
s enting its counteroffer. If this d elay is
an effectiv e s ig nal, the union then be-
liev es that the profit is low. As the
res pond er to the offer, the Rubins tein
25
At leas t this is the cas e und er their s tationar-
ity as s umption. As Lawrence Aus ubel and Ray-
mond Deneckere (1989) hav e s ince s hown, d elay
is pos s ible und er weaker as s umptions . It s hould
als o be noted that the s creening arg ument res ts
heav ily on the as s umption of a fixed ord er of offers
and counteroffers .
wag e
1 VH
UL (z,
W)
=UL
(, W(O))
UH(Z,
w
H
(O,W(O))
Preference
d irections
6 V
_
~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~......................................
1+6 L
0 z* d elay
Fig ure 15. S ig naling Equilibrium
equilibrium yield s the union a wag e
equal to w(z) = -6 VL. The payoff to the
firm if the wag e wis accepted at time z
is UH(Z,W) = 6Z(VH - w). The ind iffer-
ence curv e for a hig h-profit firm
throug h (O,w(O)) is d epicted in fig ure
15. The hig h-profit firm s trictly prefers
any offer in the interior of the s had ed
reg ion to (O,w(O)). Als o d epicted are
the flatter (d as hed ) ind ifference curv es
of a low-profit firm with payoff function
UL(Z,W)
=
5Z(VL
-
W).
Thus if the
profit
is low, the firm's cos t minimizing
s eparating s trateg y is to d elay its
counteroffer until time Z* 26
A third mod el of barg aining d elay is
the "war of attrition" where each party
tries to wait the other out. S uppos e that
the s ettlement will be w if it is the
union that conced es and w> w if the
firm conced es . Let the firm's as s es s -
ment of the probability that the union
will conced e by time t be p(t). Then if
time t is reached , the cond itional
probability that the union will conced e
in the time-interv al d t is d P-. Then
the d is counted expected pyotf from
conced ing at time t + d t is (V -
w)-d Pp
+
(V-fv w)(1--_L)e-rd t. If the firm con-
ced es at t itphas a payoff of V-wv . Col-
lecting terms , the expected net g ain to
waiting the extra time interv al is d U=
(V - w)~L- + (V - F)rd t =
v -
[(V fV-)
d p
rd t]. Note that the term in s quare
brackets is increas ing in V. Thus if a
firm with profit lev el V is better off
26
It s hould be noted that the res ult relies heav -
ily on the as s umption that the union mus t wait for
the firm to counter its orig inal offer, rather then
rev is e its own offer.
waiting until t + d t, rather than conced -
ing at t, all firms with hig her profit lev -
els are als o. It follows that the equilib-
rium s trateg ies are s eparating with the
firms with hig her profits s taying in the
competition long er.
There is a cons id erable bod y of em-
pirical ev id ence on the d uration of
s trikes and the terms of the s ettle-
ment.27 In a thoug ht-prov oking paper,
John Kennan and Wils on (1989) rev iew
the d ata and the implications of the
three theories . They conclud e that the
s ig naling mod els fare rather poorly
when confronted with the ev id ence. On
the other hand , they arg ue that both the
attrition mod el28 and the s creening
mod el are able to explain "many of the
s alient features of the d ata."
6. Finance
Finance has not only a fas cinating
array of applications of s creening and
s ig naling theory, but als o an impres s iv e
s et of inv es tig ations into their empirical
s ig nificance. As with the other field s ,
the literature is v as t, and I will focus on
s ome key is s ues rather than attempt to
be comprehens iv e. The trad itional fi-
nance literature as s umes that any in-
formation that owners and manag ers
("ins id ers ") hav e about future firm
performance is known to current and
pros pectiv e s harehold ers ("outs id ers ").
From this follows the famous Miller-
Mod ig liani Irrelev ance Theorem. In s uch
a world , chang es in capital s tructure,
d iv id end increas es , etc. hav e no effect
on the v alue of a firm's as s ets . In reality,
howev er, there are s ys tematic price effects
of announcements by firms . The s ig naling
literature arg ues that thes e announce-
ments conv ey ins id e information to the
marketplace.
6.1 Ad v ers e S election
One of the early hig hly influential
papers is S tewart Myers and Nicholas
Majluf's (1984) d is cus s ion of ad v ers e
s election when rais ing cas h to fund a
newproject. Cons id er a g roup of firms ,
all of which appear s imilar to outs id er
inv es tors but d iffer in their true v alue;
that is , firms of lower-than-av erag e
v alue are ov erpriced by the market.
Then equity-hold ing ins id ers of low-
v alue firms will be eag er to finance a
new project throug h a new is s ue of
equity. On the other hand , any s uffi-
ciently und erv alued firm will be wors e
off financing throug h a newoffering of
equity. The market is thus s ubject to
ad v ers e s election.
Cons id er the following s imple v ariant
of the Myers -Majluf mod el. Only the
owners of a firm (the "ins id ers ") know
the true v alue of a firm V(t), where
V'(t) > 0 and t E [oc,,]. S ince it will be
helpful later, we als o d efine the av erag e
v alue of all firms whos e type is no
g reater than t, V(t) =
E{V(t) I
t< t}. A new
project requires an injection of fund s C
and has a payoff with pres ent v alue B >
C. Let P be the market v alue of the firm
after the new equity is s ue. The new
s harehold ers , who prov id e C in new
fund s , then hav e a total s harehold ing of
c2
Current s harehold ers of a firm with a
P
prior true v alue of V(t) thus end up
with a payoff of U(t,P) = (1 -
Lp)(B
+ V(t)).
In a world of full information, the cur-
rent market v alue is equal to the pres -
ent v alue of the firm, that is , P = B +
V(t). S ubs tituting into the abov e expres -
s ion, U(t,P(t))
= B - C + V(t). Thus , the
ins id ers capture all the g ains from the
newis s ue.
27
S ee S heena McConnell (1989) and the refer-
ences therein.
28
Kennan and Wils on cons id er only the s im-
ples t attrition mod el in which there is no informa-
tional as ymmetry. Ad d ing as ymmetry (as d is cus s ed
here) s hould help to d is ting uis h the attrition from
the s creening mod els , for in the former it is the
hig h-profit firms that continue to hold out, while
low-profit firms s ettle early. In the latter it is the
hig h-profit firms that conced e more quickly.
v alue
(tU, V(t))
V(oW)
+ B - C .......................................
V(o ) ........................
type
Fig ure 16. Financial Market Equilibrium
With informational as ymmetry, s up-
pos e that outs id ers believ e that only
thos e types of firms s E [oc,t] will enter
the market for newequity. Then the ex-
pected v alue of the pos t-is s ue firm will
be B + V(t). Giv en s uch beliefs , outs id ers
will bid up the price of the firm to this
expected v alue. Then the v alue to ins id -
ers becomes U(t,V(t)) = (1 - =(t)(B + V(t)).
It is eas ily confirmed that U(oc,V(c)) =
V(cc) + B - C > V(oc). Moreov er, unles s the
net v alue of the project is larg e,
U(P,V(P))
<V(,). Thus , as d epicted in
fig ure 16, the two curv es mus t inters ect
at s ome t*. In equilibrium, the marg inal
firm type t* is jus t ind ifferent between
inv es ting and not inv es ting in the new
project. All hig her types are s trictly
wors e off inv es ting .
6.2 Capital S tructure
One larg e s et of papers cons id ers
how the firm's capital s tructure mig ht
s ig nal about otherwis e unobs erv able
earning s . Two early papers us e s tand ard
s ig naling arg uments . Hayne Leland and
Dav id Pyle (1977) point out that if
ins id ers are ris k av ers e, it is cos tly to
commit to hold ing a s izeable fraction of
their portfolios in the firm, rather then
be fully d iv ers ified . Howev er, the marg inal
cos t of hold ing more s hares is hig her for
ins id ers who hav e a low-quality firm.
Thus , the s ing le-cros s ing property hold s .
S tephen Ros s (1977) introd uces a bonus
(or penalty) s cheme for the manag er
bas ed on the firm's future price relativ e
to the face v alue of the d ebt is s ued . The
marg inal cos t of is s uing ad d itional d ebt
is lower for a hig her quality firm s ince
the probability of paying the penalty is
lower.
6.3 Non-d is s ipativ e S ig nals
Mos t of the literature on capital
s tructure abs tracts from is s ues of ris k and
manag erial incentiv es and focus es ins tead
on the financing of new inv es tment.
Riley:
S ilv er
S ig nals
469
s
Ins id eri
S harehold ing U2(D, S )
=Y 2 -C (hig h c)
|
_ _ _~~~~~~~~~
_I }) __-C(lw
a
_
| _ | l
g _ _ . ~~~~~~~~~
, , , __ | | _ F~~~~~~~~~eb
,~~~~Fg r
17 Efiin S eaatn
Equilbriu
S uppos e firm i with i = 1,2 need s to
rais e C in ord er to finance its inv es t-
ment plan. This plan will yield earning s
yi. Initially we will as s ume that outs id -
ers hav e full information. For s implic-
ity, we as s ume that the interes t rate is
zero s o that outs id ers d emand a return
of C and s o the net expected payoff to
ins id ers is Ui
=
yi
- C. The inv es tment is
to be financed by a combination of ris ky
d ebt and equity. We d efine D to be the
face v alue of the d ebt and S to be the
final equity s hare of the current owners .
The ins id ers thus g et a fraction S of any
income in exces s of the d ebt, that is ,
Ui(D,S )
= S E {Max (yi
-
D,O)}
=
Ui
=
yi
- C. In
the cas e of pure equity financing , this
red uces to Ui(O,S )
=
S yi
=
Ui
=
yi
- C. Thus ,
if firm 2 has a hig her expected return,
the ins id ers retain a hig her equity s hare.
Next cons id er a pure d ebt financing .
The expected return to the d ebt-hold ers
is Ui(D,l) = E{Max{yi - D,O}} = Ui =
Vi
- C.
S uppos e, following Robert Heinkel
(1982), that the firm with the hig her
mean return is als o cons id erably more
ris ky. Then the face v alue of the pure
d ebt is s ue will be hig her for firm 2.
Giv en thes e as s umptions , ind ifference
curv es for the two firms are as d epicted
in fig ure 17.
Cons id er any pair of capital s truc-
tures A and B, one to the left and one
to the rig ht of the inters ection point,
along the lower env elope of the two
ind ifference curv es . Firm 1 s trictly
prefers to finance at A and firm 2 at B.
Thus the hig h-mean/hig h-v ariance firm
s eparates by is s uing a s ufficiently larg e
amount of d ebt. In contras t to the bas ic
s ig naling mod el in which there is ov er-
inv es tment in the s ig naling activ ity
(relativ e to a world of full information),
here s ig naling is efficient. Of cours e,
firms are not limited to the s imple d ebt
equity choice illus trated here. As Mi-
chael Brennan and Alan Kraus (1987)
s how, any financial ins truments with
the property that the outer env elope of
the efficient ind ifference curv es has a
s eg ment for each type of firm can be
us ed to ind uce efficient s eparation. For
related papers applying this principle,
s ee Gunther Franke (1987), Thomas
Noe (1989), M. P. Narayaman (1988),
Georg e Cons tantined es and Bruce
Grund y (1990), and Gautam Gos wami,
Noe, and Michael Rebello (1995).
Efficient s eparation requires more
extreme as s et s tructures if firms '
earning s d is tributions can be ord ered
accord ing to cond itional firs t-ord er
s tochas tic d ominance. S uppos e that for
any pair of realizations y' and y" >
y',
Prob {y2 >
y" I
q2>
y'j}>
Prob {y7l> y" I l >
y'}. Thus , firm 2 has more probability
weig ht at the upper tail of the d is tri-
bution. Giv en this as s umption, it can be
s hown that the inters ection point of the
two ind ifference curv es lies to the
northeas t of the point E, where S = 1.
Thus efficient s eparation requires that
the hig h-quality firm choos e S > 1, that
is , is s ue d ebt and retire equity.
The empirical literature on price
effects of new is s ues and repurchas e
find s cons id erable s upport for the id ea
that announcements conv ey ins id e in-
formation to outs id ers , that is , s upport
for s ig naling theory. Theo Vermaelen
(1981) examines the effect of s tock
repurchas es on prices . He s hows that
there is a s ig nificant price effect and
that this is a pred ictor of fav orable pos t-
announcement abnormal returns . Debo-
rah Lucas and Robert McDonald (1990)
s how that firms typically float a new
is s ue after an unus ual run-up in s tock
price and that the announcement of the
newis s ue d epres s es the price. On the
other hand , Michael Barclay and Clifford
S mith (1995) arg ue that the v ariation of the
priority s tructure of corporate liabilities
acros s firms is much better explained by
incentiv e-contracting arg uments than
s ig naling .
6.4 Div id end s as S ig nals
Another puzzle for finance theory is
why firms offer d iv id end s ev en thoug h
they are d ouble-taxed . S ud ipto Bhat-
tacharya (1979) and Kos e John and
Jos eph Williams (1985) arg ue that tax-
able d iv id end s s ig nal firm quality. Fol-
lowing John and Williams , s uppos e
firms need to rais e a fixed amount of
capital to fund operations . This is fund ed
throug h the s ale of equity. The hig her
the firm's current price, the g reater will
be the ins id er's s hare of the final out-
put. The firm with a hig her expected
final output then g ains more from hold -
ing a hig her final s hare. Thus , a hig her
quality firm is willing to accept a
s maller increas e in firm v alue in return
for accumulating g reater tax liabilities
(a hig her d iv id end .)
Morton Miller and Kev in Rock (1985)
g eneralize the mod el and introd uce the
s cale of inv es tment as a choice. Let
yi
be firs t period earning s (known only to
ins id ers .) An amount z is d is tributed as
a d iv id end and the remaind er I =
yi
- z
is inv es ted . Giv en an inv es tment of I,
the firm can prod uce an expected
s econd period output of
Q(I). As s uming
(for s implicity) that the interes t rate is
zero, the pres ent expected v alue of the
firm is Vi(z)
=
yi
-
z +
Q(I)
=
z +
Q(yi
-
z).
Miller and Rock as s ume that the man-
ag er's objectiv e is to maximize a
weig hted av erag e of the current and
p
Market
Price
P
* ... ... ... ... ... ... ........... .. . . . . . . . . .
/ '
VI
(Z)'. \
zl Z2
s
Div id end
Fig ure
18. Div id end
S ig naling
future v alue of the firm, Ui(Z,P) =
ocP + j3Vi(z). With full information, the
equilibrium price is the pres ent v alue.
Thus , the firm's objectiv e is to s olv e
Max{Ui(z,P)
I
P
=
Vi(z)}.
The s olution for
the low- and hig h-earning s firms are
d epicted in fig ure 18 abov e. With full
information, the v alue of each firm is
maximized s o the equilibrium d iv id end
is where the curv e Vi(z) takes on its
maximum. Note that (z2,P2), the d iv id end -
price pair for the hig h-earning s firm, is
s trictly preferred by the low-earning s
firm ov er its full information outcome.
Thus , the hig h-quality firm mus t in-
creas e its d iv id end to z2 in ord er to
s eparate its elf.
Generalizing this arg ument, Rama-
s as try Ambaris h, John, and Williams
(1987) and Williams (1988) allow a firm
to relax its bud g et cons traint by is s uing
new equity to finance the inv es tment.
Thus the new equity can act as a s ig nal
ins tead of the d iv id end . Ev en when
d iv id end s are taxed , they s how that the
leas t cos tly s ig nal is a combination of a
new is s ue and d iv id end . While there
is plenty of ev id ence that d iv id end
chang es res ult in chang es in the market
v alue of the as s et, the appropriate tes t
is to s ee whether the announcement is
followed by "s urpris ing " pos t-d iv id end
returns . Empirical res earch (s ee, for ex-
ample, N. J. Goned es 1978; Larry Lang
and Robert Litzenberg er 1989; and
Aharon Ofer and D. S ieg el 1987) is at
bes t weak. Thus , the d iv id end puzzle
remains .
6.5 Conv ertible Debt
S uppos e a firm has conv ertible d ebt
and the market v alue of s tock reaches
the call price. While s tand ard arg uments
s ug g es t that it is in the firm's interes t to
conv ert immed iately, it is quite com-
mon for firms to wait. Milton Harris
and Artur Rav iv (1985) offer a s ig naling
explanation. S uppos e that when the call
becomes feas ible the firm has priv ate
information that earning s will be d own.
Then the firm will be ov erv alued and
there is no reas on to d elay. On the
other hand , if the ins id ers believ e that
g ood news will be forthcoming , the firm
is und erv alued . It is then more profit-
able to d elay and thus red uce d ilution
of owners hip. The immed iate conv er-
s ion of the d ebt then conv eys bad news
to the market and the price of the firm
s hould d rop. For thos e who d elay con-
v ers ion, the s ame s tory continues to
hold . S uppos e that, g iv en its priv ate in-
formation, a firm is jus t ind ifferent be-
tween conv erting and waiting t period s
after the bond conv ers ion can be
forced . Then with more fav orable pri-
v ate information, this firm has an incen-
tiv e to wait long er. Thus for d elayed
conv ers ions the price effect s hould s till
be neg ativ e.
Ofer and As hok Natarajan (1987)
look at pos t-conv ers ion returns and find
that they d ecline, as pred icted by the
s ig naling mod el. S ankars han Acharya
(1988) d irectly tes ts the Harris and
Rav iv mod el by comparing firms that
force immed iately with thos e that
choos e to d elay. Ag ain the d ata con-
forms well to the s ig naling explanation
for d elay.
6.6 Initial Public Offering s
When firms initially g o public, it is
typical for the und erwriter to s et the price
s o that the is s ue is ov ers ubs cribed .29 As
Rog er Jbbots en (1975) firs t s howed , the
res ulting und erpricing is larg e. One ex-
planation for this effect is the winner's
curs e (Rock 1986). S uppos e that bid -
d ers can be d iv id ed into thos e that are
informed and thos e that are not. The
former will not bid on the relativ ely
poor is s ues s o the uninformed hav e to
be compens ated with a low as king
price in ord er for an is s ue to be fully
s ubs cribed .
The larg es t informational as ymmetry,
howev er, s eems likely to be between
the current owner and potential buyers .
Iv o Welch (1989) arg ues that firms will
und erprice to s ig nal quality if they ex-
pect to g o back into the market later to
is s ue ad d itional equity. The hig her the
initial und erpricing , the more optimis tic
the firm is about its g rowth pros pects
(and the need for ad d itional equity). On
the other s id e of the market, the s ig nal
of a d eeper price d is count means that
buyers are willing to pay more for the
s econd is s ue.
Welch's one-parameter mod el is g en-
eralized by Franklin Allen and Gerald
Faulhauber (1989) to allowfor informa-
tion about the project to emerg e ov er
time. Mark Grinblatt and Chuan Y ang
Hwang (1989) g eneralize the mod el to
allowfor uncertainty about multiple un-
obs erv able characteris tics . In the latter
paper both the mean and v ariance of a
firm's return are unobs erv able. The two
characteris tics are s ig naled by the firm's
choice of a price d is count at the IPO
and the fraction of the equity retained
by the ins id ers .
The s ig naling s tory is then tes ted
by Naras imhan Jeg ad ees h, Mark Wein-
s tein, and Welch (1993). While they
find the ev id ence cons is tent with the
s ig naling s tory, they als o s how that
29A recent lis ting in Hong Kong of a company
d oing bus ines s in mainland China was 100 times
ov ers ubs cribed !
returns in the s ix weeks after the lis ting
als o effectiv ely s ig nal both a hig her
probability of returning to the market
and a larg er s eas oned is s ue. Thus , there
is apparently no s pecial role as s ociated
with the und er-pricing its elf. Ins tead ,
the d ata is broad ly cons is tent with the
v iewthat the market is better informed
than the s eller and the und erwriter and
that IPO und er-pricing is s imply an
und eres timate of v alue by the s eller.
7. Other Field s
While s pace preclud es a complete d is -
cus s ion of applications in other field s ,
two g roups of papers d es erv e particular
mention. Both are on the interface of
economics and politics . The firs t g roup
of papers focus es on political competi-
tion. Banks (1990a) mod els campaig n
platforms as s ig nals of cand id ates ' be-
hav ior if elected . The platforms conv ey
information about future actions , s ince
the g reater the d ev iation from them, the
more likely a politician is to incur the
electorate's wrath at the end of his
term. A multi-period mod el with s imilar
implications is d ev eloped by Harring ton
(1993). Banks (199Gb) als o cons id ers a
v oting g ame in which the political
authority has priv ate information about
the implications if the current propos als
are not v oted throug h. The way the
ag end a is s et then s ig nals the priv ate
information of the political authority.
Charles Cameron and Peter Ros end orff
(1993) as k how cong res s ional commit-
tees with ag ency ov ers ig ht authority are
able to affect an ag ency's plans when
the committee has no authority to ov er-
rule d ecis ions . They arg ue that the d e-
cis ion to hold a formal hearing (cos tly
to all parties ) s hould be v iewed as an
equilibrium s ig nal that the committee
majority is res olute. As an immed iate
implication, the ag ency's equilibrium
res pons e is typically to offer conces -
s ions to lower the cos t of the hearing .
As a final example S us anne Lohmann
(1993) offers an arg ument on why v ot-
ing can be rational d es pite the extreme
unlikelihood of being the s wing v oter.
In the s ig naling equilibrium, lead ers
us e the s ize of the majority on (s ay) a
referend um as a cue for political action.
Then each v ote has an impact, and with
the low cos t of g oing to the polls (or
mailing in), the net benefits from v oting
are pos itiv e.
The s econd g roup of papers us es s ig -
naling theory to better und ers tand the
extent to which an announcement about
g ov ernment policy is cred ible. The
mos t-cited early papers are by Robert
Barro and Dav id Gord on (1983) and
Dav id Backus and John Driffil
(1985a,b), which focus on monetary
policy and inflation. Other influential
contributions are Vickers (1986), Alex
Cukierman, and Allan Meltzer (1986),
and Kenneth Rog off and Anne S iebert
(1988).
Dani Rod rik (1998) extend s the
analys is of cred ibility of g ov ernment to
is s ues in trad e and financial liberaliza-
tion. A g ov ernment s erious about re-
form can g et better aid terms if it can
s ig nal its s erious nes s and s o d is ting uis h
its elf from would -be mimickers that are
s imply s eeking foreig n aid . This is ac-
complis hed by und ertaking prior "pain-
ful" trad e reform. S ince the mimicking
g ov ernment places a lower v alue on the
long -run benefits of the reform, the
early trad e reform becomes an equilib-
rium s ig nal as long as the propos ed aid
flowis not too larg e. A related paper by
Rog off (1990) offers an equilibrium
mod el of the bus ines s cycle. The politi-
cal bud g et cycle (from one election to
the next) is part of a proces s of multi-
d imens ional s ig naling . Multiple s ig nals
are als o featured in a paper by Tors ten
Pers s on and S wed er Wijnberg en (1993)
that explores the us e of wag e-price
controls to mitig ate the cred ibility
problem. It is s hown that a s tabilization
prog ram combining a res trictiv e mone-
tary policy with wag e price controls
is les s cos tly (more efficient) than one
us ing monetary policy as the only s ig nal.
Las t but d efinitely not leas t, three
empirical s tud ies attempt to s eek ev i-
d ence that g ov ernments d o s ig nal cred i-
bility. Allan Drazen and Paul Mas s on
(1994) us e inter-country interes t rate
d ifferentials as a reflection of the mar-
ket's es timate of the probability of d e-
v aluation. They arg ue that und er the
s ig naling hypothes is an announcement
of a continuing "toug h" monetary pol-
icy, in the pres ence of continuing un-
employment, will rais e the probability
of a future d ev aluation, thus lead ing to
a wid ening s pread . The d ata on ad jus t-
ments to the European exchang e rate
mechanis m appear to be broad ly cons is -
tent with this pred iction. Mas s on (1995)
d raws s imilar conclus ions from Britis h
d ata prior to the d ev aluation of the
Britis h pound in 1992. Finally, Karen
Lewis (1995) as ks whether interv ention
in foreig n exchang e markets by the
United S tates can be und ers tood as a
s ig nal of a toug hening s tance by the
Fed eral res erv e. If s o, s uch interv en-
tions s hould hav e been followed by cred it
tig htening . For the period analyzed
(1985-90), the d ata is broad ly cons is -
tent with s ig naling , but the ev id ence is
far from ov erwhelming .
8. Final Remarks
In this es s ay, my primary g oal has
been to s howthat a remarkable collec-
tion of new economic ins ig hts has
emerg ed from the twin theories of
s creening and s ig naling . In all three of
the primary areas of application, there
are now clear explanations of a wid e
rang e of economic phenomena, where
formerly there were jus t puzzles . My
s econd g oal has been to emphas ize tes t-
ing of the theory and to s ug g es t that
further d ev elopment of the theory will
make this eas ier. Theoretical mod els
are often of the bare-bones type, where
the objectiv e is to d emons trate that in-
formation as ymmetry and s elf-s election
prov id es a log ically cons is tent explana-
tion for s ome obs erv ed behav ior. Richer
mod els , with s omewhat more micro-
economic d etail, will prov id e a found a-
tion for both es timation and calibration.
Once fitted to the d ata, it will be pos s i-
ble to d etermine whether the equilib-
rium cos ts of s creening and s ig naling are
s mall or larg e relativ e to the benefits . If
the cos t-benefit ratio is hig h, there is a
s trong incentiv e for the market to s eek
alternativ e means of information trans -
mis s ion. It is likely that in env ironments
where this is the cas e, there will be ev i-
d ence of d irect tes ting , early monitoring ,
etc.-all prov id ed to g reatly red uce, if
not eliminate, as ymmetric information.
As I look to the future, my hope is
that in the applied field s , there will be
more effort to d eriv e theoretical foun-
d ations for tes ting the theory, particu-
larly in the field of ind us trial org aniza-
tion. S ince, in the s ig naling s tory, g ood
news is conv eyed to the market by s ome
action, this s hould be reflected in the
market v aluation of the firm. Thus for
any publicly trad ed firm, one s hould
obs erv e s tock price effects of s ig naling .
In labor economics , the connection
between the theory and tes ting has
often been rather loos e. With more
careful attention to the und erlying
mod el, new implications may lead to
new tes ts . In particular, prod uctiv ity
chang es in other s ectors hav e quite
d ifferent implications for the wag e-
ed ucation profile than a trad itional
human capital wag e profile. The con-
nection between the theory and d ata
has been explored mos t fully in the
field of finance. While quite a number
Riley: S ilv er
S ig nals
475
of papers report d ata find ing s cons is -
tent with the theory, others find the
ev id ence to be les s then compelling . In
s ome cas es contributors to the applied
theory hav e ev en und ertaken their own
empirical tes ts of the theory and found
it wanting . This is a s ig n of a healthy
field .
While the und erlying theory may
s eem well s ettled , much work remains .
I hav e emphas ized the need for further
d is cus s ion of equilibrium in which
s creening /s ig naling cos ts are not per-
fectly neg ativ ely correlated with quality.
As s uming cons ens us can be reached for
s uch mod els , we will hav e a s trong er
found ation for equilibrium in the cur-
rent mod els in which the neg ativ e cor-
relation is perfect. Mod els of imperfect
s ig nals will als o offer ad d itional oppor-
tunities for empirical analys is . When
s eparation of types is incomplete, con-
tinuing information-g athering is likely
to be important.30
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