Chapter 8 Signaling
To credibly convince buyers, sellers with peaches must take observable action that lemon sellers are
unwilling (or unable) to (eg. warranties)
Marginal cost of education is lower for workers with a high productivity
Separating equilibrium:
1. Each type of worker chooses a different action
2. Given wage function, each type of worker finds it optimal to choose eH and eL etc respectively
(Workers are optimizing their choice given the wage function w(e) )
3. Given the worker’s strategy eH, eL, ec, the wage function w(e) is perfectly competitive (each
firm receives a zero profit because there are so many workers, causing each firm to compete
fiercely with each other until the wage level equals the productivity level of workers, so zero is
the best case scenario for them, avoid negative profit)
(Firms are optimizing given the behavior of the workers)
Check whether each type of worker chooses their optimal strategy (eg. high productivity choose eH, low
productivity choose eL) by comparing their payoff (Benefit received – Cost of obtaining signaling
mechanism)
Check whether the firm is optimizing its wage function for each type of worker, by using conditional
probability calculations (Eg: Pr(High l e = 4) = 1, means that someone who chooses e = 4 is indeed high;
Pr(Low l e = 0) = 1, means that someone who chooses e = 0 is indeed low)
Signaling may or may not be welfare enhancing, depending on whether the cost of sending a signal is
more or less than the benefit involved in mitigating information asymmetry. (sometimes, education
does not increase productivity, so from society’s perspective is wasteful) As long as cost of signaling is
small compared to increase in efficiency of having more social benefit, overall, signaling can be efficient.
Pooling equilibrium:
1. Worker’s strategy is common
2. Firm’s strategy is a wage function w(e)
Conditions:
1. Each type of worker chooses the same action e = e*
2. Given wage function w(e), each type of worker finds it optimal to choose e*
3. Given the workers’ strategy e*, the wage function w(e) is perfectly competitive (each firm
receives 0 profit)
In signaling there can be multiple equilibria, within pooling equilibrium can be many pooling equilibria,
within separating equilibrium, can have many separating equilibria

Equilibrium refinement to choose the best equilibrium for the situation: for eg, Least-costly
separating equilibrium (for example low productivity guy chooses exactly e = 4, low productivity
guy chooses exactly e = 0)

Another reasonable criterion of picking the equilibrium is social norm/culture
Signaling is about evaluating candidates’ ability/superiority not just through what they say but through
observable and inferable actions. “Taking action that is costly enough so other people not willing to
undertake but the better ones are willing to take, in order for the better ones to separate themselves
from the not so good individuals”