INTRODUCTION

Greshman’s Law ; bad money derives out good

money .
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 .
The holder of an unshaved coin will therefore
withhold the coin from trade ; only the shaved
coins will circulate.

KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 1

AKERLOF’S MODEL OF LEMONS
Bad used cars derives out good cars out of market .
suppose that there are two types of used care ; peaches and lemons
1- a peach worth $3000 to a buyer & $2500 to a seller . The supply of
peach cars is fixed and the demand of possible buyers are infinite ,
so that the equilibrium price in the peach market is $3000 .
2- a lemon worth $2000 to a buyer and $1000 to a seller . There are
twice as many lemons as peaches .
We can summarize the worth of different kinds in the following table ,

lemons peaches
Sellers 1000 2500
Buyers 2000 3000

Different kinds of transaction could be recognized ;

KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 2

 AKERLOF’S MODEL OF LEMONS
1- if buyers and sellers both had the ability to look at the car and
recognize the type of the car , peaches will be sold for $3000 and
lemons will be sold for $2000.
2- if neither buyer nor seller knew whether a particular car was a
peach or lemon and assuming risk neutrality we would have no
problem .
a- a seller thinking that she has a peaches with probability of 1/3 and
a lemon with the probability of 2/3 .
She also expect that she might have a car with the expected value
equal to $1500 = (1/3)(2500) + (2/3) (1000)
b- a buyer assuming the same probability expect that she might buy a
car with expected value equal to 2333.3 = (1/3)(3000) + (2/3)(2000)
Assuming inelastic supply and elastic demand the market clears
at a price equal to $2333.3
But in reality the market is not like neither of these .
KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 3
 AKERLOF’S MODEL OF LEMONS
In the market of used cars , the seller have lived with car for a while
and knows whether the car is peach or lemon . But the buyer does
not have inside information about the car , expect for the quick
inspection when he wants to buy it .
If we assume that the buyer’s can not tell at all , the peaches
market breaks down . Suppose that cars are offered for sale at any
price above $1000 . All the lemons will appear in the market.
Peaches would appear in the market at prices above $2500 since

lemons peaches
Sellers 1000 2500
Buyers 2000 3000

At a price between $1000 and $2500 the rational buyer suppose that
peaches does not appear in the market. So the cars worth only
$2000 to the buyers.
At any price above $2500 , the expected value (price) of the car to the
buyer is equal to 2333.3 = (1/3)(3000) + (2/3)(2000) <2500 .
There will not be any offer for peaches. Only lemons will be sold
for $2000 . (demand is perfectly elastic and supply is perfectly
inelastic.
KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 4
 AKERLOF’S MODEL OF LEMONS
Suppose that there were two peaches for every lemon . So probabilities
are as follows ;
lemons ( P = 1/3) peaches (P = 2/3 )
Sellers $ 1000 $2500
Buyers $2000 $3000
Exp (buyer) = (1/3)(2000) + (2/3)($3000) = 2666.67 > 2500
This is enough for the owners of peaches to sell and we get the market
clearing price at 2666.67 with all the cars for sale . The buyer buys a
car at 2666.67 and he does not know whether it is lemon or peach.
Owners of peaches are not pleased about the lemons ; without them ,
peach owners would be getting an extra of 333.33=3000-2666.67 for
their peaches . But at least peaches can be sold .
If a particular good or service comes in many different qualities , and in a
transaction one side but not the other knows the quality in advance , the
other side must worry that it will get an adverse selection out of
entire population .
KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 5
 AKERLOF’S MODEL OF LEMONS
The classical example of this is in life /health insurance . If premiums
are set at fair rates for the population as a whole , insurance may be
a bad deal for healthy people , who then will refuse to buy .
The problem noted above becomes worse the greater the number of
qualities of cars and the smaller the valuation gap , the difference
between what a car is worth to a buyer and a seller , assuming they
have the same information . Note the following example ;
Imagine for example , that the quality spectrum of used cars runs from
real peaches , worth $2900 to sellers and $3000 to buyers , down to
real lemons , worth 1900 to sellers and 2000 to buyers . Between
the two extremes are cars of every quality level , always worth $100
more to buyers than sellers . The distribution of quality levels
between these two levels are uniform . Suppose that there are
10001 cars one of which worth $1900 to its owner and $2000 to
buyers, a second worth $1900.10 to its owner and $2000.10 to
buyers , and so on . Assuming inelastic supply and elastic demand
at every level of quality , what will be the equilibrium .
KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 6
 AKERLOF’S MODEL OF LEMONS
Total number of cars = 10001 types
Each one represents a different ( quality ) kind
Number offered Worth to buyer Worth to seller Quality of cars
10001 3000 2900 Real Peaches
…………..
11 2001 1901 Tenth quality level
better
……..
………..
3 2000.2 1900.2 Second quality
level better
2 2000.1 1900.1 First quality level
better
1 2000 1900 Real Lemon

KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 7

 AKERLOF’S MODEL OF LEMONS
Supply curve would be as follows;
Min supply price for lemons to be offered = 1900 → only one car will be offered
If p = 1900.1 → 2 cars will be offered .
If p = 1900.2 → 3 cars will be offered.
If p = 1901 → 11 cars will be offered.
If p = 1902 → 21 cars will be offered.
If p = 2900 → all 10001 cars will be offered for sale.
supply
price

2900

2100 demand
1900

quantity
2001 10001

KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 8

 AKERLOF’S MODEL OF LEMONS
Demand curve would be perfectly elastic as follows;
Buyers are willing to pay $2000 for real lemons and $3000 for real peaches.
Demand price will be between $2000 & $3000 .

If a car be offered at a price equal to P where 2000≤ P ≤ 3000 buyers

assume that only sellers who value their own cars at P or less are
willing to sell . Hence a car being sold at P has a quality level that
makes it worth on average between $2000 and $(P+100) to buyers ,
with each value in this range equally likely.

The average car being sold is worth A= $(2000+P+100)/2 to the buyer. (Since
minimum price = 2000 and actual one is ( p +100 ) )
If P= 2100 , then A=P , { A=(2000+2100+100)/2 = 2100 }
If P>2100 ,then A < P , there will not be any demand .
If P< 2100 , then A > P , there will be infinite demand .
So demand is horizontal at p=2100 (figure slide 7)
Equilibrium price will be at p=2100 , with q=2001 supply of cars.
As it is seen , only 2001 out of 10001 of the total stock of car will be offered for
sale in the market .

KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 9

 AKERLOF’S MODEL OF LEMONS
Now suppose that , between the two extremes are cars of every quality level ,
always worth $50 more to buyers than sellers .in this case the quality
spectrum of used cars runs from real peaches , worth $2950 to sellers and
$3000 to buyers , down to real lemons , worth 1900 to sellers and 1950 to
buyers . The equilibrium price will be
P = 2000 with 1001 cars offered for sale in the market,
[ A = $(1950+P+50)/2 ]
Now suppose that some item like durable goods or some services comes in N
different qualities, q1,q2,….qN . The supply for each n depends upon the
price level (P) , and is given by an upward sloping supply curve Sn(p) . As it
is explained demand depends on price (P) and average quality in the
market ( A) which is equal to ;
n qs p
n n

p 
avg
average value = q
 s p
n
n q n = quality level of type n
Sn ( p) = number of quality level of type
n
Let D( p ,qavg (p) ) be the demand function . It is decreasing in p and increasing
in qavg(p).
d D ( p ,qavg (p) ) /dp = ∂D/∂P + ( ∂D/ ∂q )( ∂qavg (p)/ ∂p )
(most likely positive ∂qavg (p)/ ∂p > 0 ) , ∂D/ ∂q >0 , ∂D/∂P < 0 → it might be
d D ( p ,qavg (p) ) /dp > 0 if the second term is big enough ,
KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 10
 AKERLOF’S MODEL OF LEMONS
It is possible that for some price levels lower than p* the slope of
demand curve becomes positive [ d D( p ,qavg (p)/dp > 0 ] and does
not intersect the supply curve as it is shown in the following figure .
in these cases there will not be an equilibrium price and market
breaks down as it is in some health insurance market .
demand
price
supply

P*

quantity

KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 11

 SIGNALING QUALITY
In reality all manners of markets subject to adverse selection do function.
Why ? Often because the side to the transaction that has the
superior information will do something that indicates the
quality of the good being sold

1- in life insurance the high quality buyer distinguish himself from the low
quality buyer and take actions that is not worthwhile for low quality buyer .
2- in used car market The high quality seller may take actions which
distinguish him from the low quality seller and is not worthy for them .

with used cars ; a- seller may offer partial warranty or b- may get the car
checked by an independent party .
In life insurance ; a- medical checkups are sometimes required . Or ;
b- golden age policy may be used . No one will be turn down but only
the benefits will greatly reduced for the beginning years of the
insurance plan . If the buyer of the insurance knows that he is dying soon ,
or if he wants to use the benefits very soon , he will not gain the whole
benefit .
KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 12
 SIGNALING QUALITY
Quality seller and his actions are not worthwhile for low quality workers.
One can think of adverse selection as an special case of moral hazard
and market signals as a special case of incentive schemes. The
incentives could be direct or indirect ;
1- direct incentives ; the seller of the low quality car may be tossed into jail
if he misrepresent the quality of car sold.
2- indirect incentives ; the seller of the used cars could be asked to give a
six month warranty if he says that the car is peach. Or the buyer may
offer $X if the seller offers him a warranty and $Y ( X>Y) , if he does not
offer him a warranty .
The two classic model of adverse selection in the literature are
1- SPENCE’S model of job market signaling and
2- ROTCHILD & STIGLITIZ model of insurance market .
In the present analysis the job market model (Spence’s setting )will be
used to illustrate both cases.
Imagine a population of workers with two qualities with equal
numbers ;
First – high quality with high innate ability , denoting t=2
Second – low quality with low innate ability , denoting with t=1

KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 13

 SIGNALING QUALITY
There are firms that will hire the workers and operates in competitive
market and making zero pure profit.
Before going to work workers seek education that enhances their
productivity. But education can not move workers from low to
high quality level ,because it is intrinsic. Each worker chooses a
level of education from a set say from e=0 to e=16 (the numbers of
schooling).
A worker of type t ( t=1 , 2) and with education level of e ( e=1 , … 16 )
worth te to a firm .note that for every level of education higher
quality worker worth twice as much as lower quality ones . Firms
when they hire a worker are unable to tell whether the worker is able
or not . But they do get to see the worker’s CV and learn how many
years they have gone to school and make wages contingent on the
number of years they have spent in school .
Workers dislike education , and less able dislike education more .
Workers also want higher wages to be sure . Workers want to
maximize the following utility .
KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 14
 SIGNALING QUALITY
Max U=Ut ( w , e ) ; where “w” is wage rate ,“e” is the education level
and “t” is the type of the worker. Worker’s indifference curve is the locus of the combination of
Utility is strictly increasing in “w” , wage and education level which brings a constant utility level .

and strictly decreasing in “e” . It is upward sloping and strictly convex. Take any point like P

(or any other point). Notice that at least one indifference curve
Shape of the worker’s indifference curve ; for low ability worker and one indifference curve for high

ability worker would pass from this point The indifference

curve of high ability worker shows a higher level of utility than

w Indifference curve of low ability

workers low ability one at any point like P .To compensate a worker for

a given increase in education requires a greater increase in

wages for a low ability worker than for a high ability worker.

So , the indifference curve of the low ability worker is always

more steeply sloped than high ability.

Direction of

increasing

preference
Wage paid

Indifference curve of high ability

workers
P

Education level

KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 15

 SIGNALING QUALITY
This assumption known as a single-crossing property. For example ;
Ut ( w , e ) = f(w) – Kt g(e) , where ; f(w) is increasing and concave
function , g(e) is increasing and strictly convex function , Kt is
positive constant with K2 >K1 .
What would happen if the ability of workers were observable (full
information model ). The high ability workers with education level
e would be paid 2e , while the low ability worker with the same
education level would be paid e . As showed in the figure in page
17 the high and low ability workers will pick different education
levels which maximizes their utility levels given these wages .
In the equilibrium education level of high ability workers (e 2 )
is greater than low ability workers (e1). So the firm could
realize the type of the workers from their education level
But we have to deal with situations in which ability level is not
directly observable . We will consider two cases ;
1- First ; job market signaling (Spence model )
2- Second ; worker self selection from a list of menu ( Rotchild
and Stigltiz model).
KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 16
 SIGNALING QUALITY,

ability of workers are observable

Indifference curve of high ability

workers

W=2e
The low ability worker knows that he should move
Indifference curve of low ability
on the W=e line and the high ability worker knows
workers
that he should move on the W=2e line, because the

ability is observable by the firm . In other words each

worker knows that his ablity is observable and he

Direction of
can not hide it . So , what he does is just a utility
increasing
maximization concerning his constraint ( w=e or
preference
w=2e ).
Wage paid

W=e

e e
1 2 e
Education level

KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 17

SPENCE’S MODEL ; JOB MARKET SIGNALING
How many years Workers choose to go to school ?.They do so anticipating some
wage function w(e) that gives wages for every level of education .
Formally an equilibrium in the sense of Spence consist of ;
a – an anticipated wage function w(e) that workers anticipate will be paid to any
one obtaining this education level e and ,
b- probability distribution πt(e) on the set of education levels for each type of
worker , t= 1 , 2 , such that the following two conditions are met ;
b1 - For each type t worker and education level e → πt(e)> 0 only if
ut [w(e) , e] achieves the maximum value of ut [w(e) , e] over all e
Condition b1 says that based upon their anticipation , the workers choose that wage
level which maximizes their utility level
b2 - for each education level e such that; π1(e) + π2(e) > 0 ;
w(e) = e [0.5π1(e) ] / [0.5π1(e) + 0.5π2(e)] + 2e [0.5π2 (e) ] / [0.5π1(e) + 0.5π2(e)]
πt(e) gives the proportion of type t workers who select education level e in
equilibrium . So πt(e) is the probability of type t worker with education level of
e . 0.5 = probability of type t in the population (opulation of workers with two
qualities are assumed to be the same)
Condition b2 express that in the equilibrium which is attained under perfect competition
, the wage rate , w(e) is equal to the conditional expected value of a worker
presenting education level e. Since ability of workers are not observable , the
eqilibrium wage should be represented in terms of expected wage (both from
workers and employers point of view). For the simplicity we assume that all the
workers
KREPS CH 17
of a given type chooseADVERSE
the SELECTION
same &level of education :
MARKET SIGNALING 18
 SIGNALING QUALITY
Two types of equilibrium - non observable quality (ability) ;
1-First type ; separating (screening ) equilibrium ;
All workers of type t=1 choose an education level e1 .

All workers of type t=2 choose an education level e2 .

Firms seeing the education level e1 , knowing the worker is of type 1 ,
pay a wage equal to e1 . And if they see the education level e2 ,
knowing the worker is of type 2 , pay a wage equal to 2e 2 .
2-Second type ; pooling equilibrium ;
workers all pool at a single education level , e* , and the equilibrium wage
will be equal to ; firms by seeing educational level e* thinks that the
probability of worker from type 1 or 2 is 1/2 .
w(e) = ( e* ) ( 1/2) + 2( e* ) ( 1/2) = 1.5 e* {π1(e) = π2(e) }
1-First type - Separating equilibrium (non observable
quality);
In order to have an separating equilibrium each type of workers will
choose different level of education ; workers of type 1 would
rather choose the wage education pair ( w=e1 , e = e1 ) than
(w = CH
KREPS 2e172 ,e = e2 ) and vice versa . Such
ADVERSE SELECTION an
& MARKET equilibrium could be seen
SIGNALING 19

in the following figure .

SIGNALING QUALITY W(e) curve must lie every where at or

both kinds of labors will maximize their utility levels with respect to below the indifference curves of the

the expected wage constraint w(e) and solutions are E and F. workers at the points that the workers

F select because E and F are the

maximization points; this is the self

Indifference curve of selection condition .

Wage level

high ability workers e and e are education level which

1 2
are selected by low and high ability worker

in the equilibrium and observed by the firm

as a signal

e
W=

e
=2 E
W
Indifference curve of low ability

workers

 e
1
e Education level
2

point E on w(e) is selected by low ability worker , so indifference curve of low ability worker and W=e line should pass

through point E and point F on w(e) is selected by high ability worker so indifference curve of high ability worker and W=2e

line should pass through point F

KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 20

What restriction should be placed on the points that are not selected
No specific restriction is needed except that ;
1- W(e) should be nonnegative for every level of e
2- we require that e ≤ w(e) ≤ 2e for all values of e .
3- it is also required that w(e)/e is non decreasing. (convex w(e) function)
first condition is self explanatory . Condition 2 says that if firms are
unsure about the worker’s ability level , firms can not be certain about
the level of education ( e or 2e ) . But according to the competition
among the firm they never pay more than 2e and not less than e . As
for condition 3 , workers assume that firms will asses a worker
who chooses education level e will be of low ability with probability
a(e). Assuming that firms all are risk neutral the wage which will be
paid in this competitive situation will be ;
w(e) = a(e) e + [ 1 - a(e) ] 2e
or w(e)/e = a(e) + [ 1 - a(e) ]2 = 2 – a(e) .
if w(e)/e is non decreasing , the a(e) should be non increasing
This means that with increase in the level of education , the
probability of the worker to have low ability is decreasing . This
means that tan(α) is increasing and w(e) wil be convex towards
the horizental axis .
KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 21
 SIGNALING QUALITY
We could rephrase the condition 2 in the following manner ; a(e) is the
probability of low ability worker choosing education level e . So firms
assessments given by a(e) are confirmed at education levels that
workers do select in the equilibrium ;
a(e) = [ 0.5 π1(e) ] / [ 0.5 π1(e) + 0.5 π2 (e) ]
πt(e) gives the proportion of type t workers who select education level e in
equilibrium. population of workers with two qualities are in equal
numbers ;
.Note that in the figure in slide no 20 the w(e) function does not lie
between e and 2e . So it does not satisfy condition (b) .

In the following figure we introduce an equilibrium which satisfies

condition b.In this equilibrium the education level which is chosen by
the worker is e^1 . That is when w=e , the education level is equal to
e^1 . In other words the indifference curve of low ability worker is
tangent to line w=e when e= e^1 .In contrast to figure in slide no. 20
the low ability worker get higher utility in the equilibrium .

KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 22

SIGNALING QUALITY
Indifference curve of

high ability workers

Wage level

W(e) curve

e
W=

Indifference curve of low ability workers which is

e higher than before .
=2
W

e^ e e
1 Education level
1 2

KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 23

Preposition 1 ; in any separating equilibrium for which the function w(e)
satisfies condition (b) , low ability workers choose precisely e^ 1 and get the
corresponding wages . In any equilibrium (separating or not) for which the
function w(e) satisfies (b) , low ability workers get at least the utility that they
get from ( w=e^1 , e=e1 ) . (this is the utility level when he introduce
himself as low quality so in pooling equilibrium the utility level should not
be lower than this)
Pooling equilibrium ; in the pooling equilibrium we assume that all the
workers choose a single level of education say e * . Numbers of high and
low ability workers are the same and each have education e* .then a(e *) = 0.5
since ;
a(e) = [ 0.5 π1(e) ] / [ 0.5 π1(e)+0.5 π2 (e) ] , if π1(e)= π2 (e) {pooling eqilibrium
condition}, then a(e) =1/2
w(e) = a(e) e + [ 1 - a(e) ] 2e → w(e*) = 1.5 e*
workers assume that firms will asses a worker who chooses education level e
will be of low ability with probability a(e)
πt(e) gives the proportion of type t workers who select education level e in
equilibrium
An equilibrium of this sort is given by the following figure in slide no. 25 .note
that the function w(e) has a kink at the pooling point . This is necessary .
Without the kink , we could not have w(e) underneath both types of indifference
curves and touching those curves at pooling point . As we can see point E
could be anywhere on the w=1.5e* line and there could be many
equilibrium . 24
 SIGNALING QUALITY
SIGNALING QUALITY
W=1.5e

Indifference curve of

high ability workers

Wage level

W(e) curve

e e
=2 W=
W

Indifference curve of low ability workers which is

higher than before .

*e Education level

KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 25

Rothschild and Stiglitz model ;
Workers self selection from a model ;
The previous assumptions are holding ; that is ;
1- two types of workers ( low and high ability ) in equal numbers .
2- πi(e) = probability of choosing education level e by worker of type i . Proportion
of i workers who choose education level e .
In the Spence model workers choose education levels in anticipation of
offers from the firm , w(e) , and we assume that those anticipation are
correct , at least for the education levels actually selected. Let’s turned
this around and suppose that the firms moves first.
Suppose that the firms offer to workers a number of contracts of the
form ( w, e ) before the workers go off to school , content in the
knowledge of what wage they will get once the school is done
( assuming they complete the number of years for which they have
contracted) . (We could also think of insurance market instead with
insurance contracts being offered to people before hand). The
context with which the model is dealing . Now consider an equilibrium
in This context . An equilibrium in the context of Rothchild and Stiglitz
consist of ;
KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 26
 SIGNALING QUALITY
a- a menu of contracts , a set of pairs [ ( w1, e1) , ( w2 , e2), … , (wk,ek) ]
For some finite integer . And
b- a selection rule by which workers are assigned to contracts or , for
each type of workers ( t ) a probability distribution πt over [1,2,3,…k],
that satisfy three conditions as follows ;
(1) – Each type of worker are assigned to the contract that is best for
That worker in the menu . In symbols , πt(j) > 0 only if ut(wj , ej )
achieves the maximum of ut (wj’ , ej’ ) for j’ = 1,2,….k and t = 1,2 .
(2) – Each contract in the menu to which workers are assigned at
least breaks even on average. Otherwise , firms offering that
contract would
withdraw from the contract . In other words wage offered by firm is not
greater than the average anticipated wage level .
In symbols for each j = 1,2,3,…k if π 1(j) + π2(j) > 0 , then ;
Wj ≤ [ 0.5 π1(j) ]/[0.5 π1(j) + 0.5 π2(j) ] ej + [ 0.5 π2(j) ]/[0.5 π1(j) + 0.5 π2(j) ] 2 ej
(3) – No contract can be created that if offered in addition to those in
the menu would make strictly positive profits for the firm offering it ,
assuming that workers choose among contracts in a manner consistent
with rule (1) .
KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 27
 SIGNALING QUALITY
Preposition 2 – In an equilibrium , any contract that is taken up by
workers must earn precisely zero expected profit per worker
(competition leads the profit towards zero).

Suppose that (w’ , e’ ) is offered and it is taken by some workers , and

earns an expected profit of ε for the firm per worker who take it . Then
because of competition among the firms there could be some firms
Which offers an amount equal to ( w’ + ε/2 ,e’). This new contract will
attract the workers who previously were attracted by (w’ , e’ ) and will
still return a profit of ε/2 , which is contradicting the condition 3 .
Now assume that the new contract may attract others besides those
who previously took (w’ , e’ ) and those others may render the
profitability of this contract. If the new workers are low ability workers
these low ability workers may be able to render the profitability of new
contract and the contradiction with condition 3 could be wipe out . But if
the new workers are high-ability workers , then it could be shown that ;

Proposition 3 ; there could not exist a pooling equilibrium ;

KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 28

 SIGNALING QUALITY

W=1.5e

Indifference curve of

high ability workers

Wage level

W’

equilibrium point E (contract E) is

E chosen among different points

1.5 e* (different contracts ) because it has
e
W= the highest utililty among four

different dotted points

e
=2
W

Indifference curve of low ability workers .

*e e’ Education level

KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 29

 SIGNALING QUALITY
Suppose that the firm are offering a menu of contracts that causes all
the workers to choose (1.5 e* , e* ) as shown in the figure . In the figure
in page 29 the filled-in dots are the menu of contracts that we suppose
Are offered . As it is seen the (1.5 e* , e* ) contract is the best , because the
utility levels are higher .
From this position , any one of the firms can offer the contract (w’ , e’ )
that is shown as a filled triangle . This is a contract that has a slightly
higher wages and education levels than (1.5 e* , e* ) , where the
increased wages more than compensate a high-ability worker but don’t
compensate a low-ability worker relative to the pooling contract. It will
only attract the high ability workers . All the low ability workers prefer the
(1.5 e* , e* ) contract .
But if all high ability workers flock to ( w’ , e’ ) contract and non of low
ability workers do so , then each worker who chooses ( w’ , e’ ) worth
2e’ to the firm that makes this offer . The firm makes a profit and
according to proposition 2 we can not have a pooling equilibrium. From this
point we can reach to the following proposition ;
Proposition 4 . It is impossible , in eqilibrium , that any contract (w , e)
is taken by positive fractions of high- and low ability workers both. So ,
only possible equilibrium is separating equilibrium .

KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 30

 SIGNALING QUALITY
Proposition 5 ; There is only a single candidate for a separating
equilibrium . In this candidate equilibrium . Low-ability workers choose
the contract ( w=e^1 , e=e^1 ) , where e^1 is defined as before ( page 23) and
High-ability worker get w=2f ^2 , e= f ^2 , (page 33)
First let us concentrate on page 33 and on the first part of the proposition .
If low ability workers are separated and choosing any other contract other
than ( w=e^1 , e=e^1 ) , a firm could add to the menu of contracts a contract
like ( w=e^1 – δ , e=e^1 ) for δ>0 small enough so that the low ability
workers prefers this to the contract they are choosing now (other
than ( w=e^1 , e=e^1 ) ) in the supposed equilibrium . But then for any value
of δ>0 , this contract must be profitable .
For explaining the second part of the proposition we should consider the f ^2
which solve the maximization of u2(2e , e ) subject to e≥ f ^1 . That is f ^2 is
the education level that high-ability workers would choose if they could
have any point along the ray w=2e for e ≥ f ^1 . We want education level to
be greater than low ability worker when w=2e, because we expect high
ability workers get higher education than low ability workers and separate
themselves from them.
KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 31
 SIGNALINAG QUALITY

Let’s now concentrate on the high-ability workers and

show that high quality workers get (w=2 f ^2 , e= f ^2 ).
Why ?
If high quality workers are separated by any other contract
other than (w=2 f ^2 , e= f ^2 ) , some firm could offer a
contract like (w=2 f ^2 - δ , e= f ^2 ) that for sufficiently small
δ would be more attractive to high ability workers than the
contract they are taking at the supposed equilibrium .
Since f ^2 ≥ f ^1 , this contract is less appealing than
the contract ( w = e^1 , e = e^1 ) for low ability workers
(lower utility level for low ability workers ). Hence this
contract will precisely attract the high ability workers
and thus for any δ >0 , this contract is precisely
profitable .
KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 32
 SIGNALING QUALITY

W = 1.5 e

Indifference curve of high ability

Wage level

workers .

w’
e
W=
E

e
=2
W
Indifference curve of low ability workers .

e^ e’ f^ =f^ Education level

1 1 2

KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 33

 SIGNALINAG QUALITY
Considering the figure in page 33 we have there depicted
separating equilibrium in a case where f ^2 = f ^1 . It could
be shown that no firm would try to break this equilibrium
point by offering a contract in a position such as (w’ , e’ )
that is shown with w’ a bit less than 2e’ and e’ a bit less
than f ^1 (point E lies above the w=1.5e line ). This contract
when added to the menu would certainly attract the high
ability workers because it offers them a higher utility level
than the one they are enjoying with ( w=2f ^2 e= f ^2 )
contract . Every high ability worker would be profitable at
this contract because wage is less than 2e’ . But this will
also attract the low ability workers because the utility level
of low ability workers are also higher than the one which
they are enjoying now . Now in this pooling equilibrium the
firm should pay a wage less than 1.5e’ to earn a profit
which is not the case in the figure.
Now consider the figure in page 35 in which point E located
below the w=1.5e line .
KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 34
SIGNALING QUALITY

W=1.5e

Indifference curve of high ability

Wage level

workers .

e
W=

E
w’ e
=2
W
Indifference curve of low ability workers .

e^ e’ f^ =f^ Education level

1 1 2

KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 35

 SIGNALINAG QUALITY
In page 35 the indifference curve of the high ability workers through the
point ( w=2 f^2 , e= f^2 ) dips below the line w= 1.5e. In this case a firm
could offer a contract such as (w’ , e’ )as shown below the line w=1.5e ,
but still above the high-ability worker’s indifference curve . This would
break the equilibrium , because even though it attracts all the workers ,
high ability and low ability , it is still profitable .
So there can not be an equilibrium at all . Any sort of pooling is
inconsistent with the equilibrium , (as proved by proposition 3). And the
only possible separating equilibrium can also be broken .
Proposition 6 ;
In the formation of Rothschild and Stiglitz , there is at most one
equilibrium. In the candidate equilibrium , low ability workers
choose ( w=e^1 , e=e^1 ) and high ability worker choose the
education level f ^2 . Such that ( w=2f ^2 e= f ^2 ) is their most
preferred point along the ray w=2e for e≥ f ^1 . If the indifference
curve for high ability workers through the point ( w=2f ^2 e= f ^2 )
dips below the pooling line w=1.5e, then there is no equilibrium at
all .if this indifference curve stays above ( or just touch) the
pooling line , then this single candidate equilibrium is an only
equilibrium .
KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 36
 SIGNALINAG QUALITY
The stories of Riley and Wilson
In many markets where signaling takes place , such as insurance , it seems
natural to suppose that uninformed parties put a menu of offers on the table
from which informed parties must choose. So conclusion of Rothchild and
Stiglitz analysis , namely that there may be no equilibrium at all , is rather
troublesome . A number of authors have suggested that the problem lies in
the notion of equilibrium proposed by Rothchild and Stiglitz . Two of the
writers are Riely and Wilson .
Riley advocates the notion of reactive equilibrium , in which to destroy a
proposed equilibrium , it must be possible to add a contract to the menu that
will be strictly profitable and that will not become strictly unprofitable if other
firms allowed to add still more contracts to the menu . In this sort of
scheme , our argument for why there are no pooling equilibrium stands up ;
we broke a pooling equilibrium by adding a contract that attracted high-
ability workers only . Given that the pooling contract remained to attract low-
ability workers . There is no way to make this pool-breaking contract strictly
unprofitable as long as the old pooling contract is remains , because as long
as KREPS
the CH
old
17 ADVERSE SELECTION & MARKET SIGNALING 37
 SIGNALINAG QUALITY
Pooling contract is present , only the high ability workers would ever
consider taking the new contract . But you are at much more risk when
adding a contract that attempts to break a separating equilibrium by pooling
high and low ability workers . For in this case , still another contract can be
added that siphons from your contract the high ability workers , leaving you
with only low ability workers . Hence , Riley concludes that reactive
equilibrium always exist , and they correspond to the single candidate
separating equilibrium .
Wilson , on the other hand , proposed a notion called anticipatory
equilibrium. In this case , to break a proposed equilibrium it must be
possible to add a contract that is strictly profitable and that does not become
strictly unprofitable when unprofitable contracts from the original menu are
withdrawn . Now if you try to break a pooling equilibrium by skimming the
high ability workers , you are at risk ; the pooling contract that you destroy
becomes unprofitable because after your addition it attracts only low ability
workers . But if it is withdrawn , all those low ability workers may flock to your
contract . On the other hand if you break a separating equilibrium with a
pooling contract , you are not at risk ; because you have created a contract
that attracts all the workers ADVERSE
, YouSELECTION
do not care if other, now unused contracts
& MARKET SIGNALING 38

are withdrawn
 SIGNALINAG QUALITY
So, Wilson concludes , anticipatory equilibrium always exist ;
sometimes there is more than one ; and pooling is possible as an
equilibrium outcome .
How do we sort between Rothschild and Stiglitz , Riley , and Wilson ?
Think in Terms of an insurance market that is regulated by some
regulatory authorities . If you think that firms can not withdraw contracts
because the regulatory committee forbid this , then Riley’s equilibrium
concept seems the more reasonable .
If you think that the regulatory authorities permit the firms to withdraw
unprofitable contracts and are very tough on adding contracts that
potentially affect the profitability of others , then Wilson’s notion seems
more reasonable .
As for Rothcilds and Stiglitz , think of regulators who call for firms to
register simultaneously and independently the contracts they wish to
offer , with no room to add or subtract subsequently.

KREPS CH 17 ADVERSE SELECTION & MARKET SIGNALING 39