1. SIGNALING QUALITY IN LABOR
MARKET

2. Education as a Signal
• Two Groups- Group 1 (Average Product= 1)
• Group 2 (Average Product = 2)
• Each output sells at Rs 1 lakh
• If you knew each firm’s quality what would be
the salary of Group 1 . Group 2?
• What if you did not know the quality of the
two?

3. Education as a Signal
• Y: years of education
• Higher education , higher costs
• Each group has different costs of education
• Group 1, C1 (Y) = Rs 4,00,000 Y
• Group 2, C2 (Y) = Rs 2,00,000 Y

4. Education as a Signal
• Assume the following decision rule is followed
by the firm
“ Anyone with education higher than y* or more
is a Group 2 person and will be given an
income of Rs 2lkh. Anyone with education less
than y* will be given an income of Rs 1lkh.”

5. Value of
Education as a Signal
education
10,00,000
B(y)
0 y*

6. Education as a Signal
• No education level between 0 and y* will be
chosen
• No education level more than y* will be
chosen

7. Choice of Education
• Group 1
Benefit: Rs 10,00,000
Cost: 4,00,000y*
Choose that y* such that Group 1 does not
educate him self
• y*> 2.5

8. Choice of Education
• Group 2
Benefit: Rs 10,00,000
Cost: 2,00,000y*
Choose that y* such that Group 1 does not educate
him self
• y*<5
• Any y* such that 2.5 <y*< 5 would do

9. Value of
Education as a Signal
education
C1 (y) = 40,000y
1,00,000
B(y)
0 y*
Group 1
Optimal Choice

10. Value of
Education as a Signal
education
C2 (y) = 20,000y
10,00,000
B(y)
0 4
Group 2
Optimal Choice

11. Education as a Signal
• Low productivity people do not get education
• High productivity people get education
• On observing education level of 4 years the
employers rightly believe the person to be of
High productivity
• Even if education does nothing to increase
productivity, some people may want to
differentiate themselves by education.

12. Warranties and Service Plans
• What is the use of Warranties?
• Can Warranties act as signal?
• Signal to what?

13. Warranties
• Problems with the car led consumers to loose
faith in Audi in late 1970s.
• In response Audi introduced “ Audi Card” or “
bumper to bumper” warranty scheme
• Audi sales increased
• Besides improving the benefit of having an
Audi, what else could have been the effect of
this warranty?

14. Audi’s Warranty
• Warranty a signal that Audi is reliable.
• If Audi was not reliable or of high quality, the
probability of repair would be high, leading to
high costs for Audi (because of the warranty)
• Any other car maker with probability of defect
higher than that of Audi would not have
offered this warranty.
• Warranties of gadgets, battery life. Duration

15. Other Examples
• Appearance a signal of wealth
• Advertising as a signal:
- Carorder.com: 50,000 , $3 metro cards for NYC
subway and paid tolls for 100 cars at all area
bridges
- “ Your commute brought to you by
Carorder.com”

16. Auction Theory
“Everything is worth what its
purchaser will pay for it.”
- Publilius Syrus (Maxim 847, 42 B.C.)

17. Auction
• Mechanism to allocate resources
• Competing against other bidders
• How much they value the product?

18. What is an Auction?
• Definition:
– A market institution with rules governing resource
allocation on the basis of bids from participants
• Over 30% of US GDP moves through auctions:
 IPOs  Wine
 Emissions permits  Art :Sotheby’s,
 Radio Spectrum Chiristie’s
 Import quotas  Flowers
 Advertisement slots:  Fish
Google, Yahoo!  Houses: Australia
 Procurement  Treasury bills
 Books: eBay, Amazon

19. Procurement Auctions
• Government takes bids for building a road
• Lowest bid wins the auction
• One Buyer, many sellers
• Issues of quality, reputation , efficiency

20. Strategy in Auctions
• How much to bid?
• When to bid?
• Whether to bid at all ?
• How to avoid winning but not regretting?

21. Can of Coins on Auction
• Write the number of coins you think are in
the can
• Write the bid that you would like to make.
• Make a personal note of these and hand over
the chit

22. Auction of Coins
Rule for Group I:
• Highest Bid wins the pot
• Pays the second highest bid
Rule for Group II:
• Highest Bid wins the pot
• Pays the your bid

23. Valuation
• Highest price at which you are indifferent
between winning and losing the object.
• Can include
I. Excitement from winning the object
II. Premium that you put on the object not
landing in your rivals hands.
III. Expected resale value

24. Private V/S Common Valuation
• Common Value Auction
– True value of the good for sale is same for all
– Bidders differ in their estimates of the true value
– e.g., FCC spectrum, drilling,
• Private Value Auction
– Each bidder knows his or her value for the object
– Independent Valuation
– Bidders differ in their values for the object
– e.g., Houses, consumption items

25. Private Value Auction
• Dinner
25

26. Common Value Auction
• Unproven oil fields
26

27. Common and Private
Value Auctions
• Each good is a composite of both Common
and Private Value goods.
• Oil Fields: Different costs of drilling the oil
field
• Houses: Resale value

28. Auction of Coins
• Winner: How did you bid for this can?
• How do you feel you have done?
• How did others bid for the can?

29. Bidding in Common Value
• Bid your estimate?
• Bid less than your estimate?
• What if everyone bid their estimate?

30. Auction as a Game
• Payoff in an Auction
• Estimate yi  v  
• If v is the true value of the object and ε is the
error
• ε is standard normally distributed
• yi has an unbiased normal distribution

31. Winner of Auction
• If everyone bids their estimate
• Winner is the one who has the highest
estimate
• And the one with the highest error

32. Winner’s Curse
• If the average bid in an auction is the actual
value of the object (Law of Large Numbers)
• If everyone bids according to their estimate
• Winner of the highest estimate would be the
one with highest error.

33. Examples
• After WW II, US govt auctioned out rights to
drill in Gulf of Mexico.
• Those who won where constantly loosing
money
• IPL (??)

34. Auction 1
Rules:
• Highest Bid wins the pot
• Pays the own bid

35. Sealed-Bid
First Price Auctions
• All buyers submit bids
• Buyer submitting the highest bid wins
and pays the price he or she bid
WINNER!
Pays $700
$700 $500
$400 $300
35

36. Auction 2: Dutch (Tulip) Auction
Descending Bid
• “Price Clock” ticks down the price
• First bidder to “buzz in” and stop the clock
is the winner
• Pays price on clock
36

37. Examples of Dutch Auctions
• Amsterdam’s flower market
• US T-bills
• Google IPO

38. Auction 3: Sealed-Bid
Second Price Auctions
• All buyers submit bids
• Buyer submitting the highest bid wins
and pays the second highest bid
WINNER!
Pays $500
$700 $500
$400 $300

39. Auction 3: Vickery Auction
• Attributed to William Vickery, Nobel Laureate,
1961
• Also called, Second price sealed bid auction
• Bids placed in a sealed bid
• Highest bidder wins
• Pays second highest bid

40. Examples of Vickery Auctions
• Stamps
• eBay
• Google and Yahoo! : GSP

41. Auction 4: Japanese Auction
• Let us change the game now.
• All teams will drop/fold their hands to indicate
no participation in the auction
• Price will rise.
• Auction will end at the price when only one
team remains in auction
• Once you drop out you can not re enters

42. Comparing Vickery and Japanese
Auction
• What is a strategy in this case?
• The bid at which you will lower your hand.
• Who wins? The one who has the highest
intended bid.
• When does it stop? When the 2nd highest
bidder stops.

43. Comparing Vickery and Japanese
Auction
• Are the winners same in Vickery and Japanese
Auction?
• Is the price that the winner pays same in
both?

44. English Auction
• Variation of Japanese Auction
• Price is raised
• Interested parties can raise the price
• Auction ends when no one raises the price
• Houses and Antique, Cattle

45. Difference between English and
Japanese Auction
• Knowledge of who is in the auction
• Knowledge of when a player drops out
Unknown in English Auction
Known in Japanese Auction

46. Comments
• Optimal Bidding strategy
• Which type of auction should be chosen? First
or Second Price Auction
• Should the products be sold sequentially or
simultaneously