Hybrid Equilibrium in Spence’s Model of Education

In Spence’s education signalling model, there are two types L and H. These
types have different productivity, ri , and per unit education cost, θi . It is
given that rH > rL > 0 and 0 < θH < θL . The firm pays a worker her
expected productivity. Prior probability of H is β.
We identify a hybrid equilibrium where L type mixes between two
actions and H type plays a pure action.
Suppose that L mixes between two actions (say qL1 and qL2 ) and H plays a
pure action (say qH ). Without loss of generality assume that qL1 < qL2 .
Step 1: It is easy to see that, in such equilibrium, qH must be equal to
qL . The reason is as follows. If qH is different from both qL1 and qL2 then
2

the firm can identify L and H by their respective action choices. But then
L should not mix between two actions as her pay-off will be strictly lower
at qL2 compared to qL1 (wage is the same, but cost of education is higher).
Similarly, if qH = qL1 then L will be identified qL2 . So L’s wage will be lower
at qL2 compared to that at qL1 (since qH = qL1 , expected wage is higher at qL1 ).
Moreover, education cost is higher at qL2 . Thus pay-off from qL2 is smaller
compared to qL1 and L should not use mixed strategy.
Step 2: Now, since qH = qL2 , L will be identified at qL1 . Hence irrespective
of the choice of qL1 , L’s wage remains the same. In equilibrium, L should
not choose a positive qL1 as it increases education cost without any benefit.
Based on the above argument, we can conclude that, if there is a hybrid
equilibrium, it must have qL1 = 0 and qL2 = qH . Let’s denote qL2 = qH = q.
Let’s assume that L plays q with probability p and 0 with probability (1 − p).
Step 3: Given the above strategies, Bayesian update of firm’s belief is
only possible at q and 0. At 0, firm identifies the worker as L type and
1
P r(H | q) = 1+p . Any other choice of education level x cannot occur in
equilibrium and hence any belief is consistent for such choices. However we
have to specify these beliefs, otherwise we won’t be able to check sequential
rationality. Let
0, if x ≤ x∗ and x 6= q, 0

P r(H | x) =
1, if x > x∗ and x 6= q, 0
where
 
∗ 1 1 p 1
x = (rH − rL ) + (1)
(1 + p) θL (1 + p) θH

1
Why we have chosen x∗ in such a manner will be clear while checking se-
quential rationality of L and H.
Firm’s wage choice is as follows:
p
 1
 1+p rH + r ,
1+p L
if x = q
w(x) = r , 6 q and x ≤ x∗
if x =
 L
rH , if x =6 q and x > x∗
Sequential rationality of L: It should be the case that L’s pay-off is maximized
(and hence equal) at 0 and q. This gives
 
1 p
rH + rL − qθL = rL − (θl × 0) (2)
1+p 1+p
1 1
⇒q = (rH − rL ) (3)
(1 + p) θL
Clearly q > 0. L does not want to deviate to any x ≤ x∗ because her wage
will remain rL but education cost will be positive. Also L does not want to
deviate to x > x∗ because her pay-off
rH − θL x ≤ rH − θL x∗ as x > x∗
1
≤ rH − θL (rH − rL ) (explained below)
θL
= rL
The second line of the above inequality holds because θL > θH and hence
 
1 1 p 1 1
+ ≥
(1 + p) θL (1 + p) θH θL
 
1 1 p 1 1
⇒ x∗ = (rH − rL ) + ≥ (rH − rL )
(1 + p) θL (1 + p) θH θL
Sequential rationality of H: H’s pay-off from q is
 
1 p
rH + rL − θH q
1+p 1+p
=rL + q(θL − θH ) (From Equation 2)
H does not deviate to any x ≤ x∗ because then the firm will believe that she is
L type and H’s pay-off will be (rL −θH x), which is lower than [rL +q(θL −θH )]
(because θL > θH ).

2
 H also does not deviate to x > x∗ because her pay-off will be [rH − θH x]
which is smaller than [rH − θH x∗ ]. Check that [rH − θH x∗ ] is equal to [rL +
q(θL − θH )] (H’s pay-off from q) by using Equation 1 and Equation 3. In fact
x∗ was chosen in a manner that prevents H’s deviation to a higher level of
education (you should also check that x∗ > q).
Therefore we have identified a class of hybrid equilibrium (one for each p
strictly between 0 and 1), where L mixes between two h education leveli and
1 1
H chooses a pure action. Type L chooses education (rH − rL ) (1+p) θL with
probability
h p andi 0 with probability (1 − p). Type H chooses education
1 1
(rH − rL ) (1+p) θL
. Firm’s belief:

1

 1+p
, if x = q
P r(H | x) = 0, 6 q and x ≤ x∗
if x =
1, if x > x∗
