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Managerial Economics: Topic 1 2 Adverse Selection and Signaling Good s with different quality: Adverse Selection Signaling equilibria Pooling equilibria Mass Markets with quality problems We’re considering mass markets for homogenous goods = everyone produces goods that look the same BUT

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Managerial economics topic 1 2 adverse selection and signaling l.jpg

Managerial Economics: Topic 12Adverse Selection and Signaling

Goods with different quality: Adverse Selection

Signaling equilibria

Pooling equilibria

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Mass Markets with quality problems

We’re considering mass markets for homogenous goods

= everyone produces goods that look the same


are not necessarily of the same quality

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The market for ‘lemons’

Used car market:

  • It’s a perfectly competitive market: there are lots of buyers and lots of sellers.

  • To simplify, there is only one kind of used car on the market: three-year-old Holden Barinas.

    • There is just one going price in the market: no one will pay more or sell for less than the going price.

    • Buyers and sellers see the going price, and decide if they want to participate in the market.

  • Unfortunately, there are really 2 qualities of cars on the market: good cars and lemons.

  • If buyers cannot tell them apart, the market for good cars can fail.

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Who knows what?Case 1. Complete information

Sellers and Buyers know whether it’s a good car or a lemon:

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Case 2 – uncertainty:

  • Buyers don’t know whether it’s a good car or a lemon

  • Sellers don’t know whether it’s a good car or a lemon

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The market for ‘lemons’: case 3 – asymmetric information

  • Sellers know whether it’s a good car or a lemon

  • Buyers cannottell a good car from a lemon before they buy.

     Will you buy if the price is at least $8,000? NO!

  • At this price, every seller will want to sell. But this means that if you buy a car it has a 60% chance of being a lemon (worth $6,000 to you) and a 40% chance of being good (worth $10,000 to the buyer). So the expected value of a car to the buyer is $7,600. So you will not pay more than $8,000 for a car with an expected value of $7,600!

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The market for ‘lemons’: case 3 – asymmetric information

  • Suppose the buyer cannot tell a good car from a lemon before they buy.

  • Will you buy if the price is between $6,000 and $8,000?

  • NO!

  • At this price, only the sellers of ‘lemons’ will want to sell. Every car being offered is a lemon and you will not pay more than $6000.

    So we expect that the market will have a price between $3,000 and $6,000, with only lemons sold.

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Case 3: asymmetric information

If buyers don’t know whether it’s a good car or a lemon, it’s one price for good or bad.

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Adverse selection

  • Adverse selection is defined as:

    “a lower price means a lower quality of cars in the market.”

  • The problem of adverse selection can lead to the complete collapse of the market for good cars.

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Adverse selection

Any evidence of such problems in the used car market?

(Dutta, Strategies and Games)

  • The average car depreciated 37% in the first year. By the end of the second year it had depreciated 50%. (If you tried to sell your 1994 car in 1996, you would get only half the price that you had paid for it a mere two years before.)

  • Only about 1% of new (1 or 2 year old) cars are lemons, so most sales should be from people with changed circumstances.

    • Suppose you would pay 80% of new if there were no adverse selection

    • But if the price is only 80% of new, some people with changed circumstances decide to keep the car (give it to kids, drive it to their new home,…)

    • now cars for sale only worth 70%.

    • But if the price is only 70%, …

The asian fire sale and the market for lemons khanna and palepu hbr july august 1999 125 134 l.jpg
The Asian Fire sale and the market for “lemons” Khanna and Palepu, HBR July-August 1999, 125-134

  • Asian crisis led to a serious liquidity crisis for many Asian firms

    • Created the need to sell off assets

    • large market for assets arose at the time of the crisis

  • However, in many of the countries experiencing crisis (especially Thailand and Indonesia) there is insufficient reliable public information on the value of an asset. (Inadequate accounting practices, inadequate government supervision, lack of transparency in record-keeping.)

    • buyer cannot know the true value of the asset, only the average value in market

    • certain assets that are worth more than average are pulled off the market, and average value keeps falling = market breakdown

  • “The few companies that have been buying in Asia, such as GE Capital in Thailand, are the ones that chose to build a direct understanding of the local markets in the years before the crisis.”

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Information and market failure

  • Why do health insurance companies worry about healthy young married women?

    What is the outcome, if insurance companies raise the price of insurance to that group?

  • Why is car insurance more expensive for younger drivers?

  • Why do insurance companies make you pay the first part of any claim (the deductible)?

  • Case – are higher interest rates better for banks?

  • Adverse selection can also lead to ‘statistical discrimination’ and rationing.

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Gresham’s Law

Imagine an economy in which the currency consists of gold coins. The holder of a coin is able to shave a bit of gold from it in a way that is undetectable without careful measurement; the gold so obtained can then be used to produce new coins. Imagine that some of the coins have been shaved in this fashion, while others have not. Then someone taking a coin in trade for goods will assess positive probability that the coin being given her has been shaved, and thus less will be given for it than if it was certain not to be shaved. The holder of an unshaved coin will therefore withhold the coin from trade; only shaved coins will circulate.

“Bad Money Drives Out the Good”

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Bad staplers drive out the good

  • Suppose that there are firms producing good staplers and firms producing bad staplers

  • Customers can’t tell the two types of staplers apart  staplers are all sold for the same price

  • But producers of bad staplers have lower costs than producers of good staplers

    • If it’s a competitive market, firms keep entering so long as positive profits are being earned, and enter until profits are driven to zero

    • Bad stapler producers keep entering until their profits are nearly zero

    • But that means that producers of good staplers are losing money!

    • Firms producing good staplers exit the market (or switch to producing bad staplers)

      = works like an improvement in efficiency, but for the wrong reason! (uninformed customers)

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Responses to adverse selection

  • Note that the problem of adverse selection harms the uninformed parties and some of the informed parties:

    • In the lemons example, it meant that buyers could not buy good cars.

    • But also sellers of good cars could not get a reasonable price for their cars. (Even if the price is still above their WTS, the presence of lemons means they earn less.)

  • Uninformed buyers may try to overcome the information asymmetry by investing in ‘search’

  • Informed sellers may try to overcome the problem by

    • Getting quality certification from government or independent body

    • Offering warranties

    • Other signaling strategies

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Warranties and the market for ‘lemons’

Let’s go back to our used car market, and suppose that there are lots more buyers than sellers  the price rises to buyers’ WTP.

Sellers of good cars want to offer a warranty—but what kind of warranty?

Ex: Let’s say the warranty is a (one-time) $2000 payment in the event of a breakdown

But if that warranty makes buyers willing to pay close to $10,000 instead of $6,000, sellers of lemons will want to offer the warranty, too

 Customers can’t assume the warranty means it’s a good car

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The purpose of Warranties -- a philosophical question

What is the purpose of offering a warranty to customers?

  • Insuring the buyer against all possible costs of getting a lemon

    • Extra compensation beyond the cost of repair if it breaks down

    • Rental car while it’s being repaired,…

    • this can get very, very expensive!

  • Sending a credible signal of your quality: prove that you’re not a lemon

    How? By offering a warranty that would be unattractive for a lemon seller to offer, even if it convinced buyers!

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Example: Fedex versus U.S. Post Office

  • Suppose customers don’t know which is more reliable

  • They follow a simple rule of thumb: use more / pay more for whichever express service offers better compensation for non-delivery

  • Initially no compensation at all, but Fedex decides to offer a small compensation for late delivery

  • U.S. Post Office matches them, keeps all their customers

  • Fedex raises their compensation a little

  • U.S. Post Office matches them, keeps all their customers

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Example: Fedex vs. U.S. Post Office

  • Eventually, Fedex gets to a compensation level that is not worth it for the U.S. Post to match, even to keep their customers. What happens then?

  • Customers go to Fedex / pay more for Fedex

  • U.S. Post is not getting much benefit from their lower compensation

  • They go back to zero compensation.

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Example: Fedex versus U.S. Post Office

Key lessons from this case:

  • The purpose of the signal is to “separate” yourself from the bad quality: send a message that is too costly for the bad to send, even if it would convince customers that they are good quality

  • That’s how you set the signal: exactly at the level where it’s not worth copying (no higher!)

    • Look at the incentives of the bad type to set the signal level

  • Purpose is not to compensate customers for the risk of you being a bad type.

  • Don’t start something that you don’t want to finish: it may be too costly to start signalling, even if you are the good type

    • Suppose customers don’t really value the Fedex compensation, except as a guarantee of quality

    • If Fedex is doing OK before the compensation, may not be worth it

Warranties l.jpg

Let’s return to our car market example. Currently only lemons on the market, for $6000.

Suppose that good cars never break down. However, a lemon has a high probability of breaking down (that is why it is a lemon). Say lemons break down with an 80% probability. (But cars only break down once.)

Fixing a broken down car is expensive – about $5,000.

Suppose now that a car seller offers you the following deal – “Buy the car for $9,000. If it breaks down, the seller will fix your car for free.”

Should you buy the car?

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So if the buyer knew that it was a good car they would accept the deal.

Don’t buy



Offer deal

Breakdown (zero chance)

Good seller

(-$4,000; $?)


Don’t offer deal

 No sale

No breakdown (100%)


($1000, $1000)

Warranties25 l.jpg

But the buyer can infer that the seller is good

– the seller of a lemon would not offer the deal.

(3000; 0)

Don’t buy


Offer deal

Breakdown (80%)

Lemon seller



Don’t offer deal

 Sell for $6000

No breakdown (20%)

(3000; 0)


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Don’t buy

(3000; 0)


Offer deal

Breakdown (80%)

Lemon seller

Expected payoff for

lemon seller if buyer

accepts offer is


So the lemon seller

will not offer this deal!


Don’toffer deal

No breakdown (20%)

(3000; 0)

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  • So the warranty ‘works’

    • Only the good sellers will offer the warranty

    • Buyers can buy the car with the warranty, sure that they are buying a good car (and will never need to use the warranty)

    • Because it is not worth while for the sellers of ‘lemons’ to copy the warranty – their cars break down and the warranty costs more than the increased price that they receive for their cars

  • “The dog that didn’t bark:”

    • If good firms are offering a warranty

    • Then if a firm doesn’t offer a warranty, customers correctly infer that it’s a bad firm. Silence is informative!

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Evidence on Warranties?

From Dutta, Strategies and Games:

  • Of all used cars purchased, 20% are sold through new car dealerships and another 15% are sold through used car dealerships. Dealerships typically offer warranties on the used cars they sell.

  • The average price of a used car in 1994 was about $11,500. The average private-party sale price on a used car was about $2,000 less than the average sale price at dealers.

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  • The warranty is an example of a ‘signal’ that the ‘good’ seller can send to the buyer.

  • In our example here the signal had no cost to the ‘good’ seller. This is not generally the case.

  • For a signal to ‘work’ it requires three features

    • The cost to the ‘bad’ type must be high enough so that they do not want to pretend to be a ‘good’ type

    • It must be less costly to the ‘good’ type than to the ‘bad’ type.

    • Even given the cost, it must be better for the ‘good’ type to distinguish themselves than be mistaken for a ‘bad’ type.

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Bargaining revisited!

  • Signaling applies whenever you need to distinguish yourself from another type of person/firm/group.

    Example: Back to bargaining.

  • We assumed complete information = all parties to an agreement know the WTP or WTS of each player

  • Observation: If there is incomplete information, your trading partner knows his WTP/WTS, but you don’t know it for sure.

  • Why does that lead to delay?

  • Why might that rule out agreement, in some instances?

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Other examples: the early career rat race

  • Suppose there are ordinary and talented workers

  • Your boss can observe the quality of your work but not how difficult you found the task

  • If everyone spends the same time, the talented workers will be recognised and gain promotion

  • So the ordinary workers work harder to try and ‘appear’ to be talented

  • So to distinguish themselves, the talented workers also have to work hard

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Other examples: the early career rat race

  • What will be the outcome?

    • Could get a separating equilibrium. This is where the signal ‘works’. The talented workers work too hard but are recognised. The ordinary workers just give up.

    • Or could get a pooling equilibrium. In this situation, the ordinary workers work hard and talented workers work normally. The boss interprets ‘ordinary’ performance as a sure sign of lack of talent. But the boss cannot infer anything from exceptional work – because everyone is doing it!

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Signaling = “Lifting the fog”

  • Signaling can overcome information problems

  • But it’s costly to the ‘good’ type who is trying to distinguish herself from the ‘bad’ type

  • Choosing the wrong signal just means the ‘bad’ type will copy you. Despite the cost of the signal, there is no gain in information

  • So: it is important to carefully choose your signaling strategy. It needs to be low cost to you and high cost to others, so that it will be ‘believed’ and cannot be ‘jammed’ by the bad types.

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Pooling Equilibria = “preserving the fog”

  • If you’re a bad type (or you might be) you want the bad types and the good types to look the same

  • You mimic the ‘good’ type:

    • Follow the herd: Forecasters try and keep their forecast in line with the others; it’s more costly to make a mistake, if you’re the only one who makes it.

  • You make it harder to get clear information about your quality = ‘signal jamming’

    • Create variability and complexity in performance measures

    • Bury information where possible:

      • If you refused a project, bury it so that no one finds out you might have been wrong (e.g. ET)

      • Refuse to collect more information (e.g. Continental Corporation refusing an extensive due diligence by a buyer)

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MATH: How to find a Credible Signaling strategy.

  • If the good types send a credible signal, what does that say about the equilibrium?

    • Customers (or business partners) believe you’re the good type when you send the signal  you get the “good deal”

    • Customers assume that if you didn’t send the signal, you’re the bad type  you get treated like a bad type

       Spell out exactly what this will mean, in this situation.

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MATH: How to find a Credible Signaling strategy.

  • What makes the signal credible?

    • Bad types don’t want to send it. (That is, they know they could fool customers by sending the signal, but it’s not worth it.)

    • Draw a decision tree, to find a signal that bad don’t want to send.

  • Last: Check that good types are better off than in the pooling equilibrium (where customers can’t distinguish them from bad)

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Warranties and the market for ‘lemons’

  • Back to our used car market: suppose that now there are only 30% lemons

  • There are lots more buyers than sellers  the price rises to buyers’ WTP.

  • What is the pooling equilibrium?

  • If good cars break down with a 5% probability and lemons break down with a 50% probability, what is the signaling equilibrium?

  • (Firms can offer warranties of the following form: If your car breaks down, I pay you $X.)

  • Which equilibrium do the good sellers prefer?

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Real world: How to find a Credible Signaling strategy.

  • You need to find the dimension along which your quality is much better than your competitors

    = points you to a signal that is cheaper for you to send than them

    ex: FedEx versus US Post

    • unless your quality is much better, it’s not worth it to signal!

  • Take a gradual approach:

    • Offer a small warranty, and point out that your competitor is not

    • Competitor will copy you, if customers respond  keep raising the level of the warranty until competitor drops out (and let customers know!)

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From the other side of the market:Ask good types to signal!

  • If you’re the buyer, suggest a warranty!

  • If you’re in a business transaction and you need to know the type of your business partner, give them an opportunity to signal:

    • Insurance companies offering car insurance:

    • Offer two types of policy: {large deductible with low price}; or {small deductible with very high price}

    • Low risk choose the first policy: they don’t expect to have an accident, so paying the deductible if they do have an accident is not a problem

    • High risk choose the second policy

       This is called “screening”

  • Price discrimination, revisited:

  • Monopolist wants to offer a “better deal” to low-WTP types; they have to signal that they are the “good” types by accepting a cost, like delay.