Competition With Hidden Knowledge (Riley, JPE 1985)

Competition with Hidden Knowledge
Author(s): John G. Riley

Source: Journal of Political Economy, Vol. 93, No. 5 (Oct., 1985), pp. 958-976
Published by: The University of Chicago Press
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Competition with Hidden Knowledge
John G, Riley
Universityof California, Los Angeles
In markets where product quality is diffuse and verification by

buyers is sufficientlycostly, high-qualitysellers have an incentive to
"signal"to buyers by investing in some activitythat is more costly for
low-qualitysellers. Unfortunately, with competition among buyers
over the price paid for each level of the signal,there is, in general, no
Nash equilibrium. However, it is sufficient for equilibrium that (i)
low-qualitysellers would, under symmetricinformation,choose not
to enter the market, and (ii) the rate at which the marginal cost of
signaling declines across types is sufficientlylarge.
The large and rapidly growing literature on principal-agent problems

is conveniently divided into papers that focus on problems of hidden
actions and those that focus on problems of hidden knowledge. The
latter are also naturally divided into studies of incentive schemes in
which the principal is a monopolist' and those in which a large num-
ber of principals compete for agents' services. Here we focus on the
many principal-many agent problem when knowledge is hidden.
The first formal discussion of the issues is provided by Spence
(1974), who examines markets in which sellers (agents) have private
information about the quality of their products. There is also some
activity that is less costly for sellers with higher-quality products. Rec-
ognizing that this activity is a potential "signal" of product quality,
buyers pay a premium for higher levels of the signal.
Helpful discussions with Larry Kotlikoff, Jim Mirrlees, Sheridan Titman, Brett
Trueman, and Michael Waldman and suggestions by the referees are gratefully ac-
knowledged. This research was supported by the National Science Foundation.
1 One example is the choice of an income tax scheme by the tax authority when ability
is unobservable (Mirrlees 1971). Another is the choice of an optimal selling scheme by
the owner of a unique object (Riley and Samuelson 1981).
[Journal of Political Economy, 1985, vol. 93, no. 5]

X 1985 by The University of Chicago. All rights reserved. 0022-3808/85/9305-0006$01.50
958

COMPETITION 959
Spence modeled all market participants as price takers. Each seller
observes the market return to signaling and chooses the signal that is
individually optimal. In equilibrium, all those buyers making trades
based on signals find that their prior beliefs are confirmed ex post.
While very much in the spirit of traditional Walrasian, "price-
taking," models, the conclusion that emerges is strikingly different.
Instead of there being a unique equilibrium (or possibly a finite set of
equilibria), Spence shows that market signaling equilibria form a con-
tinuum.
More recent papers by Riley (1975, 1979a) and Rothschild and
Stiglitz (1976) make it clear that this result is critically linked to the
assumption that all individuals are price takers. In the traditional full-
information equilibrium, each agent is small relative to the markets in
which he trades and there is no incentive to attempt price competi-
tion-hence the price-taking assumption. However, with the infor-
mational externality that underlies a market signaling equilibrium, it
is no longer necessarily the case that price-taking behavior is individu-
ally rational.
Focusing on the application of signaling to the purchase of insur-
ance, Rothschild and Stiglitz consider the simplest case of two types of
agents-high and low risk. They show that, unless the proportion of
high-risk types is sufficiently great, all the "Walrasian" signaling
equilibria are unstable. That is, there is always some alternative op-
portunity open to a buyer that, in the absence of reactions by other
buyers, generates strictly greater expected profits. Equivalently, if the
market is modeled as a noncooperative game, in which the buyers
(principals) first announce what they will pay for different levels of
the signal and sellers (agents) then respond, there is no Nash equilib-
rium in pure strategies.
My own papers focus primarily on the opposite polar case-a con-
tinuum of agents. Adopting the game-theoretic terminology, a cen-
tral conclusion is that nonexistence is generic in the class of models
considered by Spence. In particular, raising the price offered to those
choosing the lowest observed level of the signal is always profitable.
Moreover, price competition may be profitable at higher levels of the
signal as well.
There have been several attempts to overcome this failure to ex-
plain signaling behavior. Each of these builds on a paper by Wilson
(1977), which begins with the premise that agents will anticipate the
responses of others when they consider new actions. The least de-
manding of the alternative equilibrium concepts is the "reactive equi-
librium."2 Loosely, a set of strategies s, .. . ., s for n competing agents
2
For a comparison of three alternative non-Nash-equilibrium concepts see Riley
(1979b).

960 JOURNAL OF POLITICAL ECONOMY
is a reactive equilibrium if two conditions are satisfied. First, for any

agent i and any alternative strategy si that raises i's payoff there is
another agents who can benefit by reacting at the expense of agent Z.
Second, there is no further reaction by a further agent that can make
agent j's reactions unprofitable. The idea then is that agent i will
recognize agent j's clear incentive to react and therefore will be de-
terred from choosing si rather than s*.
As argued in Riley (1979a), of the sets of signal-price contracts that
separate out the different types of agents, there is a unique Pareto-
dominating set, and this is a reactive equilibrium. Moreover, there can
be no reactive equilibrium in which high-quality, low-signaling-cost
agents are pooled with low-quality, high-signaling-cost agents. Thus
the reactive equilibrium is unique.
While the assumption of this greater level of sophistication is plausi-
ble for some applications of the theory, there are other applications
for which it is possible to take a more skeptical view. Thus, in this
paper, an alternative way out of the nonexistence dilemma is exam-
ined. Instead of modifying the equilibrium concept, the route chosen
is the adaption of the model itself. It is argued that, despite the nega-
tive conclusions of the published literature, there is a family of signal-
ing models that generate an equilibrium satisfying the strong Nash
equilibrium condition that all price competition must be unprofitable,
in the absence of reactions by other price setters.
These models differ from those appearing in the literature in only
one critical way. Rather than assume that all agents would enter a
particular market in a world of perfect information, I assume that,
even in such a world, a positive fraction of the agents would choose
not to participate. In the labor market, for example, suppose 0 E [0,
1] is the productivity of a given type in the production of a particular
commodity. Then, as long as there is some alternative job opportunity
offering any worker a wage WA only those for whom 0 > WA have an
incentive to produce this commodity.
Similarly, in the signaling of project quality by insider stockholding
(Leland and Pyle 1977) and the signaling of loan quality by collateral
or loan size (Milde and Riley 1984; Bester 1985), those entrepreneurs
with sufficiently low-quality offerings would not be financed in a
world of costless information about quality.
Even in insurance markets, with perfect information about loss
probabilities, nonparticipation will often be plausible. Under fair in-
surance, the risk of loss L with probability p will be fully covered by a
premium pL. Then those with sufficiently high probabilities of loss
may be better off not undertaking the risky activity.
This simple modification of the basic Spencian model is important

COMPETITION 961
because it eliminates the profitability of price competition at the low-
est observed level of the signal. The primary focus of the paper is
then to seek out conditions under which price competition is also
unprofitable at higher levels of the signal. As Spence emphasized, an
activity is a potential signal if it is less costly for those agents selling
products with a higher-quality product. The central result of this
paper is that if the proportional rate of decrease of the marginal cost
of signaling, with respect to quality, is sufficiently high, there exists a
Nash equilibrium. That is, price competition is never profitable.
The paper is organized as follows. Section I lays out a principal-
agent model with hidden knowledge. Section II examines, in detail,
the case in which there is a discrete number of types of sellers. In
particular, conditions are derived under which there is a Nash equi-
librium for both the labor market model of Spence and the insurance
market model of Rothschild and Stiglitz. Section III considers the
labor market model under the assumption of a continuum of agents
and shows that, in this limiting case as well, there are reasonable
conditions under which a Nash equilibrium exists. Some concluding
remarks appear in Section IV.
I. A Many Principal-Many Agent Model

with Hidden Knowledge
Consider a market in which each of the set of potential sellers (agents)
can provide one unit of a commodity or service. Sellers can also
choose the level, s, at which to engage in some sales-related activity,
that is, to "signal." Differences among sellers are assumed to be pa-
rameterizable by a single hidden characteristic 0 E 0. We shall there-
fore refer to a seller as being of "type 8."
A contract (s, r) between a buyer (principal) and seller is a payment
r in return for signal level s. If a type 8 seller accepts (s, r) the value of
his product is V(0, s) so that the buyer's profit is
H(0, s, r) = V(0, s) - r. (1)
Types are parameterized so that higher levels of 0 imply higher
product value V(0, s). It is also assumed that V is nondecreasing in s.
Preferences over alternative offers (s, r) are represented by the
utility function U(0, s, r), where U is increasing in the return r and
decreasing in s. For every seller there is also a mutually exclusive
alternative to trading in this market that yields a utility level UA.
Finally, assume that the marginal cost of signaling, that is, the in-
crease in return required for a seller to be willing to increase his
signaling activity, diminishes with 0. Formally,

au (,r
MCS = -d as (sr)(2)
ds |u ar (8, r)
decreases with 0. Condition (2) guarantees that, for any set of offers,
the choice of signal level s(0) will be nondecreasing in 0.
II. Nash Equilibrium with a Finite Number

of Types of Seller
Rather than discuss this model in abstract terms, let us begin with a
simple example of labor market signaling. A type 0 worker who
chooses signal level s has a value to each of the firms in some industry
of
V(0, s) = 0. (3)
Each worker also has an opportunity to work elsewhere for a wage rA.
The cost of signaling at level s is C(8, s); thus the net return to type 0 if
offered the wage contract (s, r) is
U(O, s, r) = r - C(0, s). (4)
Condition (2) then reduces simply to the requirement that the mar-
ginal cost of signaling aC/as be lower for more productive workers.
As Rothschild and Stiglitz (1976) showed for the two-type case, no
contract that attracts more than one type can be part of a Nash (or
stable Walrasian) equilibrium. More generally (see Wilson 1977) we
have the following proposition.
PROPOSITION 1. A Nash equilibrium contains no pools.
Given this result we need only examine sets of contracts that sepa-
rate out all those types who choose to signal. To simplify the analysis
further we assume there are just three types of agents so that 0 = {Oo,
01, 02}. We further assume that
00 < rA < 01 < 02- (5)
Each worker chooses the contract (s, r) that maximizes his net gain
U(O,s, r). Moreover, if more than one contract yields the same utility
we assume that the contract selected is the one with the lowest level of
the signal.3
One possible set of contracts that separates out the three types is the
set {Eo, E I, E2} depicted in figure 1. Type 0o, with the steepest indiffer-
3 This essentially technical problem, of nonunique optimal choices, disappears when
types are distributed continuously.

COMPETITION 963
return to r
signaling i U0 U1
I
wage1
Ed I~~~~~~~~~
rA
00 _ :
-S
SI SD 2 signal
FIG. 1 -Pareto-efficient separating set of contracts
ence map, J0 = U(00, r, s), chooses the contract Eo. Type 0H, with
indifference map U1 = U(01, r, s), chooses El. Finally, type 02, with
the least steep indifference map, U2 = U(02, r, s), chooses E2.
Note that only those workers with productivity exceeding rA find
signaling desirable. Thus the allocation of workers between the two
industries is efficient. Note also that the profit on each contract is
zero. Note, finally, that each type 0, is indifferent between his choice E,
and the choice E1? 1 of type 0i+ 1.
It should therefore be intuitively clear that, of all sets of contracts
that separate out the different types, the set {Eo, E1, E2} is Pareto
efficient. Formally, modifying only slightly arguments in Riley
(1979a) and Engers and Fernandez (1984), we have the following
result.
PROPOSITION 2. Characterizationof the Pareto-efficientset of separating
contracts.Suppose the hypotheses of Section I are satisfied. Then, of
all the sets of contracts that are individually not unprofitable and
separate out those types who signal, there is a unique set that is Pareto
efficient for the agents. This set (i) allocates types efficiently between
those who signal and those who do not; (ii) generates zero profits on

each contract; and, if the set of types is discrete, (iii) has the property
that if E, is the choice of type Oi,
Ei - El-+,
Oi
As shown in figure 1, {Eo, E1, E2} is not a Nash equilibrium. Note

that any offer in the dotted region is attractive to types 01 and 02.
Then if the average productivity of these two types, 012, is as depicted,
any alternative offer in the interior of the diagonally shaded region is
strictly profitable.4
Given the distribution of types who choose to signal, the question
we wish to address here is whether there are conditions under which
such profitable alternatives do not exist.
First of all, as long as the proportion of type Oo,who choose not to
signal, is sufficiently large, it will never be profitable to make an offer
that attracts all three types. Given this assumption, the diagonally
shaded region is the entire set of potentially profitable alternatives.
Since the indifference curve U(01, s, r) = Ul bounding this set is
upward sloping, the most profitable of these alternatives is the point
D, where the indifference curves
U(00, s, r) = U(00, 0, rA) UA (6)

U(02, s, r) = U(02, S2, r2) UE
intersect.
Holding fixed the preferences of type Oo,we can vary D by altering
the shape of the indifference curves of the other two types. We then
seek conditions under which rD > 012. Clearly this will be the case if
XD < 02 - 012, that is, if
XD 02 012 _ fl
XZ 02 -01 f +T2'
where fi is the proportion of type 0i in the population. Since XZ ex-

ceeds XY, it follows that a sufficient condition for rD to exceed 012 is
that
XD< f' (7)

XY fl +f2
4 Using fig. 1, it is easy to see why, in a Nash equilibrium, there can be no pooling of
different types. Suppose, e.g., that both type 1 and type 2 were to choose the contract
(SD, rD). For this contract to be not unprofitable, rD -< 612. But then there is always
an alternative contract, indicated by the point T in the figure, that is preferred only by
type 02 and that is strictly profitable.

COMPETITION 965
From (4) and (6) we can rewrite (7) as
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ {52 8C (0 2 , s )ds
f___ C(02, S2) -
C(02, SD) _
as
fl + f2 C(01, S2) - C(01, SD) r3C (0 s)ds
as
But
t
SDas (01, s)ds SEssI [ as (2s
as 1
maac
JSD7 ( 2,s ) s L as ( JBs)
Therefore wage competition is unprofitable if, for all s,
ac (02 s)
as < _f__8
ac ( S) fl +f (8)
as (1s
For the three-type case we have therefore proved the following prop-
osition.
PROPOSITION 3. Sufficient conditionsfor a Nash equilibrium:theseparable
case. Suppose alternative opportunities are such that a large number
of sellers with low-value products would, in a world of full informa-
tion, choose not to enter the market. Then, if the proportional rate of
decline with 0 of the marginal cost of signaling, aC(0, s)las, is
sufficiently large, the Pareto-efficient set of separating contracts is a
Nash equilibrium.
With more than three types it should be clear that the same argu-
ment will hold for every potential pool of two types. Actually, an
almost identical argument can be used for larger pools as well. Thus
the proposition is quite general.
I now show how the result can be extended to the more general case
in which the utility function, U(0, s, r), is nonseparable and the valua-
tion function, V(0, s), depends not only on type but also on the level of
the signal s.
PROPOSITION 4. Sufficient conditionsfor a Nash equilibrium.Suppose
alternative opportunities are such that a large number of sellers with
low-value products would, in a world of full information, choose not
to enter the market. Suppose also that, for the general model of
Section I, the marginal cost of signaling is, for each of n types of
agents, nonincreasing in the return to signaling, r. Then the Pareto-
efficient set of separating contracts is a Nash equilibrium whenever

the proportional rate of decline in the marginal cost of signaling with

respect to 0,
a dr
ao ds U(O, s, r) = U
dr
ds U(O, S, r) = U
is sufficiently large.
Proof. As above I analyze the special case with just three types. The
generalization to n types is straightforward. Consider figure 1 again.
Since V(0, s) is nondecreasing in s, the average value of types 01 and 02,
if they both choose the contract D, is no greater than
__ f1V(01, S2) + f2V(02, S2)

fl ? f2
Then, just as in the earlier argument, there are no profitable alterna-
tives if XDIXY is sufficiently small. But
fS2 dr
XD= ds
D ds U2
where the integral is along the arc U2 = U2k and
Y=f dr ds
ds u'
along the arc U' = U . By hypothesis (drlds)lvis decreasing in r. Then
XD |d | 2ds,
along the arc U' = U1, so that
( dr I
XD JS1D ds U2
XY 2
Sdr ds
DdCS U I
where both integrals are along the arc U1 = UE,
dr
ds U2
S max
Se [SD, S2] dr
ds LI
along the arc U1 = UE.

By making the proportional rate of decline in the marginal cost of

COMPETITION 967
signaling with respect to 0 sufficiently large, the right-hand side of
this inequality can be made arbitrarily small. Then the offer D can be
chosen arbitrarily close to the horizontal line r = V(02, s2) and hence
above V12(s2).Q.E.D.
This more general result, as well as covering generalizations of
Spence's (1974) labor market model to allow for a direct productivity-
enhancing effect of the signal, can also be applied to Rothschild and
Stiglitz's (1976) model of insurance with differing risk classes. In the
latter model, each individual, with von Neumann-Morgenstern util-
ity function u(-) and initial wealth w, can insure himself against a loss L
by paying a premium p. Alternatively, by coinsuring, that is, accepting
a deductible of s, the individual receives a premium reduction of r. In
the no-loss state, which occurs with probability 0, wealth is therefore
X - (p - r) n + r, where n - p. In the loss state wealth is w -
L + (L - s) - (p - r) = n + r - s. Expected utility can then be
expressed as
U(0, s, r) = Ou(n + r) + (1 - 0)u(n + r - s). (9)
If a type 0 individual accepts the insurance contract (s, r) the ex-
pected profit on this contract is
fl(0, s, r) = p - r - (1 - 0)(L - s) V(0, s) -r. (10)
From (9) the marginal cost of signaling is
aU
dr _ as
ds
dS U=U(O.s,r) aU
dr
--(1 -)u'(n + r-s)
Ou'(n + r) + (1 - O)u'(n + r - s)
0 u'(n + r)
1-10 u'(n + r-s)
It follows immediately that, as required, the marginal cost of signaling
declines with the quality of the insurance risk (the probability of no
loss, 0).
We now ask under what conditions the hypotheses of proposition 4
are most likely to be satisfied in an insurance market. From (1 1), the
marginal cost of signaling is nonincreasing in r if u'(n + r)/u'(n + r -
s) is nondecreasing in r, that is, if
0 < u(n+ r) = [A(n + r-s) -A(n + r)] u'

ar u'(n + r-s) u'(n + r -s)
(12)

where A(X) = - [u"(w)/u'(w)]is the degree of absolute aversion to risk

at wealth level w. Assuming, as is usually argued, that absolute aver-
sion to risk does not increase with wealth, it follows that inequality
(12) is indeed satisfied.
Finally we consider the rate of decline of the marginal cost of sig-
naling. Differentiating the logarithm of (11) by 0 we obtain
a dr u'(n + r)
1
80 dsc (1 0)2 u'(n + r-s)
dr + 0 u'(n + r)
dsu I -0 u'(n+r-s)
=~~~~~~~~
(1 + r - s) + 0(1 -0)
_ 0)2Uf(n
u'(n + r)
From proposition 4, a Nash equilibrium exists if this expression is
sufficiently large. Note that as the probability of no loss, 0, approaches
unity, the denominator approaches zero. Therefore, as long as the
loss probabilities are all sufficiently low, the Pareto-efficient separat-
ing contract set is a Nash equilibrium.
III. Nash Equilibrium with a Continuous

Distribution of Types
While the simple derivations of the previous section provide some
intuition into the importance of the proportional rate of decline of
the marginal cost of signaling, the arguments themselves rest heavily
on the assumption that differences between neighboring types are
discrete. This is easily seen by referring back to the sufficient condi-
tion (8) for the simple labor market model. Note that if the marginal
cost of signaling varies continuously with 0,
(02, S)
lim as1 > f
02 1 01 aC (f0 5) f ?T2
as
Thus condition (8) is only satisfied whenever the difference between
neighboring types of seller is sufficiently large. However, this result
does not itself imply that propositions 3 and 4 are false. To demon-
strate this, consider the simple labor market case in which the cost of
signaling C(s, 0) = sI0. Then U(0j, s, r) = r - (s/0i). Consider figure 1
once again. Since E1 and D lie on the same indifference curve for type
00,
SD -SI
rD - 01 - (13)
0o

COMPETITION 969
Similarly, since EI and E2 lie on an indifference curve for type 01 and
D and E2 lie on an indifference curve for type 02,
I-
01 -02 = 2 (14)
01
and
02 - rD= 52 SD (15)
02
Multiplying (13) by 00, (14) by 01, (15) by 02, and then adding we
obtain
2 - 0001 - rD(02 - 00) + 01(01 - 02) = 0- (16)
Since we are interested in the limit as both 02 - 01 and 01 - 00
approach zero, let k = (02 - 0)I(01 - 00).
Substituting into (16) and rearranging we obtain rD = (k02 + 01 )/(k
+ 1). Comparing this expression with 012 = (fl 0 + f202)/(fl + f2), it
follows that there is a Nash equilibrium if 1I(k + 1) <fl/(f, + f2).
This conclusion holds even in the limit, as the difference across
types goes to zero, which strongly suggests that a similar result holds
when the set of sellers forms a continuum. Unfortunately, analysis of
the continuous case with nonseparable preferences is extremely intri-
cate. However, clear-cut results are obtainable for the simple labor
market model. To focus on essentials we make a further simplification
and assume that the cost of signaling takes on the special multiplica-
tive form C(s, 0) = sIm(0), m'(0) > 0. Workers are assumed to be
distributed continuously on the interval [a, b], with a < rA < b. The
cumulative density function for 0, F(O), is assumed to be twice con-
tinuously differentiable and strictly increasing on [a, b].
From proposition 2 we seek a set of contracts that allocates the
workers across industries efficiently, separates out all those types who
signal, and generates zero profits. Thus we seek a wage function r =
W(s) such that s(0), which solves
max{U[0, s, W(s)] = W(s) - mk) (17)
also satisfies
W[s(0)] = trA, 0 > rA (18)

0, 0 > rA
5 The assumption that C(O, s) = s/m(O)is not as restrictive as it might seem. Sup-
pose instead that z is the level of the signaling activity with signaling cost C(0, z) =
A(z)/m(O),where A(z) is strictly increasing. Then we can always define the inverse func-
tion z = A- l(s) and define the equivalent signaling cost function C(6, s) =C[O, A- '(s)]
= s/m(O).

r
return to
signaling u
wage 'A
W(s)
rA
/~~~~A I
0 s(&) signal
FIG. 2.-Pareto-efficient separating wage function
Such a wage function is illustrated in figure 2. Type ', observing W(s),

chooses s(3). As required the resulting wage paid, W[s(O)],is equal to
this worker productivity, '.
Suppose, as we shall later confirm, that W(s) is differentiable. Then,
for any type choosing a positive s we require
W [S(o)] - 1> = 0. (19)
Combining (18) and (19) yields the ordinary differential equation

m(W)W'(s) = 1, W(O) = rA. Integrating and making use of the bound-
ary condition we obtain
) m(w)dw - s. (20)
Note that the wage schedule W(s), given implicitly by (20), is differ-
entiable as hypothesized. We now seek conditions under which this
schedule is a Nash equilibrium. Actually, we consider only the ques-
tion of whether W(s) is a local Nash equilibrium. That is, we seek
conditions under which each alternative contract (s, f) sufficiently
close to the schedule (s, W(s)) is unprofitable."
6 In an earlier version of this manuscript (Riley 1983), conditions for a Nash equilib-
rium are also examined. It is shown that, as long as one mild additional restriction
holds, a local Nash equilibrium is also a Nash equilibrium.

COMPETITION 971
First we consider a new wage offer r with no signal required. This is
also depicted in figure 2. Since an agent of type rA is just indifferent
between signaling and not signaling, his indifference curve through
(0, rA) must, as depicted, be tangential to W(s) at s = 0. Of course,
with r > rA type rA strictly prefers the new offer. Indeed there is an
interval of types [rA,0) who are strictly better off under the new offer
than if they signal. In Riley (1979a) it is established that, for ri
sufficiently small, this new offer will attract an interval of types with
an average productivity in excess of the offered wage. However, with
the alternative opportunity yielding a wage rA<rK all those types on
the interval [a, rA] also find the new offer attractive. Then the average
productivity of those accepting the new offer is 0 0dFIF(').
As ri-* rA, 0 -> rA, and hence the average productivity approaches
f' OdF/F(rA),which is strictly less than rA. Then for r > rA and
sufficiently close the new offer is unprofitable.
The other alternative is a new offer (s, f) designed to attract all
those types on some interval (,3, y). This is illustrated in figure 3. An
agent of type 3, with indifference curve Up through his best signaling
point (s(13), 3), is just indifferent between the latter and the new
alternative. Similarly an agent of type y is just indifferent, while all
those for whom 0 E (,(, -y) strictly prefer (Q,?).
We next obtain an expression for r' in terms of 13and -yand then
compare this new offer with the average productivity of those accept-
ing it.
From (17) the steepness of an indifference curve for type 0 is
l/m(0). Then (s^,i) must satisfy
r_- 1 _r
-y_2
-
1)
s - s() m(3) - s(^y) m(y)
Eliminating sgwe then obtain
r[m(-y) - m = ym(y) - 3m(3) - [5(y) - S(13)]. (22)
But, from (18) and (20)
s(y) - s(s) = { m(w)dw (23)
= ym(y) - Pm) - wm'(w)dw.
Substituting (23) into (22), we obtain
T wm'(w)dw
mry) - m.13) (24)
M(Y) - MP

r
returnto
signaling
wage U
r~~~~~~~~~~
A
I I I~~~~~~~~~~
s (j3) g s~y signal

FIG. 3.-Interior wage competition
Thus, to attract workers with productivity in the interval (P3,-y) an

employer announces the new offer Ci,r?~,where r' satisfies (24) and S^
satisfies (2 1).
To determine the profitability of such an offer we must compare it
with the average productivity of those accepting, that is,
VOF'
(O)dO
Jr~~~~~~~
~(25)
-
F(-y) - F(f3)
To do this we fix 03at some arbitrary level and examine the change in rf
and 0 with -y as y I1 P3.Appealing to L'Ho'pital's rule we have the
following useful result, which is proved in the Appendix.
LEMMA 1. Define y(-y) = f~fOH'(O)dOI[H(-y) -
H(P)], where H(j is
twice continuously differentiable. Then (i) y(13)= f3, (ii) y'(13) 1/2, -
and (iii) y"(13)= '/6 H"(P3)/H'(p).

To focus on the effect of the proportional rate of decline in the
marginal cost of signaling we now make the further simplifying as-
sumption that C(O,s) = sl'. Then
as

COMPETITION 973
the elasticity of the marginal cost of signaling, is constant. Appealing
to lemma 1, it follows that, for My- , sufficiently small, r exceeds 0 if
and only if e - 1 > OF"/F'.We have therefore proved the following
proposition.
PROPOSITION 5. Necessaryand sufficient conditionsfor a local Nash equi-
librium. With a positive mass choosing the reservation wage rA, and
with signaling cost function C(0, s) = SlOe,the Pareto-efficient separat-
ing wage function is a local Nash equilibrium if the elasticity, with
respect to 0, of the marginal cost of signaling exceeds the elasticity of
the density function by more than unity, that is, e > 1 + [OF"(O)IF(O)].
If the inequality is reversed there is no local Nash equilibrium.
In addition to noting the close link between this result and those of
the previous section, it is interesting to consider the benefits from
signaling for different signaling cost elasticities. From (23), with m(w)
I
- we s(O) = wedw. Therefore, the equilibrium cost of signaling for
type 0 is
C[0,s(0)]= s() = O: (j edw.
Note that the integrand is a decreasing function of e for all 0. We have

therefore proved the following proposition.
PROPOSITION 6. Ranking signaling technologies. With signaling cost
function C(0, s) = slAeand productivity independent of s, the higher is
e (and hence the larger is the proportional rate of decline in the
marginal cost of signaling), the greater is the equilibrium return to all
those signaling.
Combining propositions 5 and 6 we observe that those values of e
that generate sufficiently large potential gains from signaling also
lead to the existence of a Nash equilibrium. Thus, at least in the labor
market case, the equilibrium problems tend to arise only when the
potential gains from signaling are small.
IV. Concluding Remarks

Taken together, the results above indicate that there are quite rea-
sonable assumptions, for both the insurance market and labor market
applications, under which the many principal-many agent problem
has a (unique) Nash equilibrium. Furthermore, in the labor market
application, the sufficient conditions for a Nash equilibrium are
satisfied whenever the gains to those signaling are sufficiently large.
However, it should be emphasized that, for the limiting case of a
continuum of agents, we have derived our result only under simpli-
fying separability assumptions. While it is my conjecture that these
assumptions are not necessary, further generalization seems likely to
be technically intricate.

Turning to more fundamental theoretical issues, it should be noted

that all the published literature makes the key assumption that there
is only one hidden characteristic. Therefore a further important step
will be to develop models with multiple characteristics. Some prelimi-
nary work by Engers (1984) suggests that parallel results are possible
with equal numbers of characteristics and signals. However, this area
remains largely unexplored.
Another theoretical simplification made in this paper is the as-
sumption that the opportunity cost of choosing to signal at all is the
same for each type. Especially in the labor market case it seems much
more plausible that those workers with a high productivity will have a
higher opportunity cost. While introduction of a reservation utility
UA(O),which varies across types, complicates the technical details, it is
clear from the recent work by Engers and Fernandez (1984) that the
conclusions are essentially unchanged.
A further feature of the model deserving clarification is the order-
ing of the players' moves. In the analysis here, it is the uninformed
buyers who must make the first move, each announcing a menu of
contracts to the sellers. While this is the natural assumption for some
applications, there are others in which the order is reversed. For
example, in the signaling of higher earnings via dividend increases
(Bhattacharya 1979), it is the uninformed outsiders who respond to
the dividend signals of the informed insiders. As Stiglitz and Weiss
(1983) show, the problem in such models is not the lack of a Nash
equilibrium but the plethora of such equilibria. Very recently, how-
ever, Kreps (1984) has argued that the only "stable" Nash equilibrium
is the Pareto-dominating separating set of contracts examined in this
paper.
Finally, it would be incomplete to finish without some comment on
how behavior can be modeled when the underlying assumptions im-
ply that no Nash equilibrium exists. As indicated in the Introduction,
there have been various attempts to model an equilibrium in which
principals take into account anticipated reactions when considering
alternative actions. To illustrate, consider figure 1 once more. Since
the contract set {E0, El, E2} is the Pareto-efficient separating set, any
new offer, such as D, that generates strictly positive expected profits
must involve pooling. Then there is always a reaction such as T that
skims the cream from the pool. As a result the initial "defection" D
generates losses while the reaction T makes profits on every agent
who accepts it. It thus seems plausible that the principal considering
the defection D will recognize that the reaction T poses a serious
threat. As a result he will be deterred from choosing to offer D. The
Pareto-efficient separating set is then a reactive equilibrium.
The crucial step in this argument is the assumption that at least one

COMPETITION 975
other principal will be able to exploit the opportunity arising from the
announcement of a new offer, such as D, before the new offer has
generated significant profits. (Alternatively, once offered, D cannot
be quickly withdrawn, so that the initial profits are offset by later
losses as other principals respond.) Therefore, in using a non-Nash
equilibrium concept to model behavior in some specific market it is
important to begin by considering the reasonableness of the quick
reaction hypothesis.
Appendix
LEMMA 1. Define y(y) = f OH'(0)dOI[H(-y)-H(1)], where H() is twice con-

tinuously differentiable. Then (i) y(1) = 3, (ii) y'(3) = l/2, and (iii)y"(13)=
1/6 H (P)IH'(P).
Proof.Conclusion i follows from a direct applicationof L'H6pital'srule. To
prove ii define A(wy) H(y) - H(p). Then we can rewrite y(-y) as
f OA'(8)dO
Y(-Y)=
A(-y)
Integrating the numerator of this expression by parts we obtain
JA(O)dO
A(y) (A1)
Next differentiating by y we obtain
A'(y) 7 A(O)dO
Y (y) - (A2)
(_)2
Applying L'H6pital'srule twice and noting that A(^) = 0 we obtain ii.

Using ii and (A2) we can also write
,() _()- A'(y) 7A(O)dO - V/2A(y)2

-Y- P (5-y )A (-)2
As y - the left-hand side approachesy"(1).Applying L'H6pital'srule three
times, the right-hand side approaches A"(13)/6A'(1).This proves iii, since the
derivativesof A and H are identical. Q.E.D.
References
Bester, Helmut. "Screening versus Rationing in Credit Markets with Imper-
fect Information." A.E.R. 75 (September 1985), in press.
Bhattacharya, Sudipto. "Imperfect Information, Dividend Policy, and 'the
Bird in the Hand' Fallacy." Bell J. Econ. 10 (Spring 1979): 259-70.

Engers, Maxim. "Equilibrium with Asymmetric Information." Ph.D. disserta-

tion. Univ. California, Los Angeles, 1984.
Engers, Maxim, and Fernandez, Luiz. "On the Existence and Uniqueness of
Signalling Equilibria." Mimeographed. Charlottesville: Univ. Virginia,
1984.
Kreps, David M. "Signalling Games and Stable Equilibrium." Research Paper
no. 758. Stanford, Calif.: Stanford Univ., Grad. School Bus., 1984.
Leland, Hayne E., and Pyle, David H. "Informational Asymmetries, Financial
Structure, and Financial Intermediation."j. Finance 32 (May 1977): 371-
87.
Milde, Helmuth, and Riley, John G. "Signalling in Credit Markets." Discus-
sion Paper no. 334. Los Angeles: Univ. California, 1984.
Mirrlees, James A. "An Exploration in the Theory of Optimum Income
Taxation." Rev. Econ. Studies 38 (April 1971): 175-208.
Riley, John G. "Competitive Signalling."J. Econ. Theory 10 (April 1975): 174-
86.
. "Informational Equilibrium." Econometrica 47 (March 1979): 331-
59. (a)
. "Noncooperative Equilibrium and Market Signalling." A.E.R. Papers
and Proc. 69 (May 1979): 303-7. (b)
. "Competitive Signalling Reconsidered." Discussion Paper no. 294.
Los Angeles: Univ. California, June 1983.
Riley, John G., and Samuelson, William F. "Optimal Auctions." A.E.R. 71
(June 1981): 381-92.
Rothschild, Michael, and Stiglitz, Joseph E. "Equilibrium in Competitive In-
surance Markets: An Essay on the Economics of Imperfect Information."
Q.J.E. 80 (November 1976): 630-49.
Spence, A. Michael. Market Signaling: Informational Transfer in Hiring and Re-
lated Screening Processes. Cambridge, Mass.: Harvard Univ. Press, 1974.
Stiglitz, Joseph E., and Weiss, Andrew. "Alternative Approaches to Analyz-
ing Markets with Asymmetric Information: Reply." A.E.R. 73 (March
1983): 246-49.
Wilson, Charles A. "A Model of Insurance Markets with Incomplete Infor-
mation." J. Econ. Theory 16 (December 1977): 167-207.


Competition With Hidden Knowledge (Riley, JPE 1985)

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Competition with Hidden Knowledge

Author(s): John G. Riley

This content downloaded from 131.175.12.86 on Thu, 22 May 2014 10:38:33 AM

In markets where product quality is diffuse and verification by

The large and rapidly growing literature on principal-agent problems

[Journal of Political Economy, 1985, vol. 93, no. 5]

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This content downloaded from 131.175.12.86 on Thu, 22 May 2014 10:38:33 AM

is a reactive equilibrium if two conditions are satisfied. First, for any

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I. A Many Principal-Many Agent Model

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II. Nash Equilibrium with a Finite Number

3 This essentially technical problem, of nonunique optimal choices, disappears when

types are distributed continuously.

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This content downloaded from 131.175.12.86 on Thu, 22 May 2014 10:38:33 AM

As shown in figure 1, {Eo, E1, E2} is not a Nash equilibrium. Note

U(00, s, r) = U(00, 0, rA) UA (6)

where fi is the proportion of type 0i in the population. Since XZ ex-

XD< f' (7)

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This content downloaded from 131.175.12.86 on Thu, 22 May 2014 10:38:33 AM

the proportional rate of decline in the marginal cost of signaling with

__ f1V(01, S2) + f2V(02, S2)

where the integral is along the arc U2 = U2k and

along the arc U' = U . By hypothesis (drlds)lvis decreasing in r. Then

along the arc U' = U1, so that

where both integrals are along the arc U1 = UE,

along the arc U1 = UE.

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0 < u(n+ r) = [A(n + r-s) -A(n + r)] u'

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where A(X) = - [u"(w)/u'(w)]is the degree of absolute aversion to risk

III. Nash Equilibrium with a Continuous

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max{U[0, s, W(s)] = W(s) - mk) (17)

W[s(0)] = trA, 0 > rA (18)

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Such a wage function is illustrated in figure 2. Type ', observing W(s),

W [S(o)] - 1> = 0. (19)

Combining (18) and (19) yields the ordinary differential equation

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s(y) - s(s) = { m(w)dw (23)

= ym(y) - Pm) - wm'(w)dw.

Substituting (23) into (22), we obtain

This content downloaded from 131.175.12.86 on Thu, 22 May 2014 10:38:33 AM

s (j3) g s~y signal

Thus, to attract workers with productivity in the interval (P3,-y) an

and (iii) y"(13)= '/6 H"(P3)/H'(p).

This content downloaded from 131.175.12.86 on Thu, 22 May 2014 10:38:33 AM

C[0,s(0)]= s() = O: (j edw.

Note that the integrand is a decreasing function of e for all 0. We have

IV. Concluding Remarks

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Turning to more fundamental theoretical issues, it should be noted

This content downloaded from 131.175.12.86 on Thu, 22 May 2014 10:38:33 AM

LEMMA 1. Define y(y) = f OH'(0)dOI[H(-y)-H(1)], where H() is twice con-

Applying L'H6pital'srule twice and noting that A(^) = 0 we obtain ii.

,() _()- A'(y) 7A(O)dO - V/2A(y)2

This content downloaded from 131.175.12.86 on Thu, 22 May 2014 10:38:33 AM

Engers, Maxim. "Equilibrium with Asymmetric Information." Ph.D. disserta-

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