Intermediate Microeconomics, Games and Behaviour Week 6
The most rapidly growing area in economic theory in the last decades has been the area of
information economics: The study of situations of asymmetric information (one economic agent
knows something that another economic agent does not know).
Sequential decisions with incomplete information:
1) Adverse selection: Nature begins the game by choosing A's type, unobserved by P. A and P
then agree to contract. Adverse selection happens before the contract is signed, you don't
know the quality. There is information asymmetry, which occurs when the seller knows
more about a product than the buyer. Asymmetric information leads to adverse selection
which results in market failure.
2) Signalling: In many instances it will be to the benefit of the
informed party to reveal her type to the uninformed
opponent. Signalling is a strategy the informed party can use
to reveal its private information in order to prevent effects
of adverse selection. The seller does this to differ between
good and bad quality. There are three types of signalling:
quality signalling, education signalling, entry deterrence.
A central problem in signalling is the credibility of signals. What guarantees a receiver of a
signal that a signal has been sent by a certain type of signaller. Thus, with incomplete
information this results in the average.
There are pooling and separating equilibria of signalling games that fall into two classes:
Pooling equilibria: all types of Player 1 choose the same action, thus reveal nothing to
Player 2 about the quality.
Separating equilibria: each type of Player 1 chooses a different action, thus in equilibrium
revealing his type to Player 2. A separating equilibrium can exist if the cost of the signal is
sufficiently lower for the "good" type than for the "bad" type. The cost of the signal has to
be sufficiently lower in the case of higher quality than in the case of lower quality goods.
Some common components of signalling games:
1. Nature chooses a type for Player 1 that Player 2 does not know, but “cares about”
(common values).
2. Player 1 has a rich action set in the sense that there are at least as many actions as there
are types, and each action imposes a different “cost” on each type.
3. Player 1 chooses an action first, and Player 2 then responds after observing Player 1’s
choice.
4. Given Player 2’s belief about Player 1’s strategy, Player 2 updates his beliefs after
observing Player 1’s choice. Player 2 then best responds according to his beliefs.
The most rapidly growing area in economic theory in the last decades has been the area of
information economics: The study of situations of asymmetric information (one economic agent
knows something that another economic agent does not know).
Sequential decisions with incomplete information:
1) Adverse selection: Nature begins the game by choosing A's type, unobserved by P. A and P
then agree to contract. Adverse selection happens before the contract is signed, you don't
know the quality. There is information asymmetry, which occurs when the seller knows
more about a product than the buyer. Asymmetric information leads to adverse selection
which results in market failure.
2) Signalling: In many instances it will be to the benefit of the
informed party to reveal her type to the uninformed
opponent. Signalling is a strategy the informed party can use
to reveal its private information in order to prevent effects
of adverse selection. The seller does this to differ between
good and bad quality. There are three types of signalling:
quality signalling, education signalling, entry deterrence.
A central problem in signalling is the credibility of signals. What guarantees a receiver of a
signal that a signal has been sent by a certain type of signaller. Thus, with incomplete
information this results in the average.
There are pooling and separating equilibria of signalling games that fall into two classes:
Pooling equilibria: all types of Player 1 choose the same action, thus reveal nothing to
Player 2 about the quality.
Separating equilibria: each type of Player 1 chooses a different action, thus in equilibrium
revealing his type to Player 2. A separating equilibrium can exist if the cost of the signal is
sufficiently lower for the "good" type than for the "bad" type. The cost of the signal has to
be sufficiently lower in the case of higher quality than in the case of lower quality goods.
Some common components of signalling games:
1. Nature chooses a type for Player 1 that Player 2 does not know, but “cares about”
(common values).
2. Player 1 has a rich action set in the sense that there are at least as many actions as there
are types, and each action imposes a different “cost” on each type.
3. Player 1 chooses an action first, and Player 2 then responds after observing Player 1’s
choice.
4. Given Player 2’s belief about Player 1’s strategy, Player 2 updates his beliefs after
observing Player 1’s choice. Player 2 then best responds according to his beliefs.
