Wednesday, April 25, 2012

Classes #25 and 26 Highlights

Pocket Aces
In our last unit of game theory, we studied signaling. The goal of a signal is to influence the beliefs of the rival about some payoff relevant characteristic. In our setting, that characteristic was the worker's productivity. In firm settings, the characteristic is typically the quality of the item or service. To work, a signal must be understood by the receiver of the signal. That is, the message must meaningfully convey some information about the characteristic.

Most of the time, a firm or individual is interested in separating their product or service from the competition. The key to a good signal is one that a firm possessing the characteristic can send but which cannot be sent by someone lacking this characteristic. Often, this boils down to a difference in the cost of sending the signal. For instance, a car manufacturer with a low probability of breakdown can issue a comprehensive warranty that lasts for a long time whereas an unreliable manufacturer will find such a warranty too expensive to issue.

An MBA has some of these same characteristics. While the monetary cost of the degree is the same regardless of the quality of an individual, a low type will struggle to get through the courses, and this extra work effort will be costly in terms of quality of life, balance, and so on. A high type will not have to work as hard to get through the curriculum and hence will find the experience more pleasant and less costly.

Even though a separating equilibrium exists, it may not be optimal for anyone. Recognizing this, industry groups might agree not to permit certain types of signaling thus leaving all members better off. For instance, the industry council of distilled spirits manufacturers agreed not to advertise on television for many years. This agreement amounts to the enforcement of a pooling equilibrium over this signal.

Key Learnings

1. A signal works by changing beliefs about a payoff relevant characteristic. Thus, it is only effective if thie connection is readily understood by its recipient.
2. Using a signal to differentiate requires that the signal cannot be easily imitated by low quality types. This may be because it is prohibitively costly for them to do so or because it is technologically infeasible.
3. A signal is not useful simply because it is costly to send. It must be differentially costly, i.e. cheaper for high types than for low types to send.

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