1



Imperfect Signaling

and the Local Credibility Test

Hongbin Cai, John Riley and Lixin Ye*

November, 2004

Abstract

In this paper we study equilibrium refinement in signaling models. We propose a Local Credibility Test (LCT) that is somewhat stronger than the Cho and Kreps Intuitive Criterion but weaker than the “strong Intuitive Criterion” of Grossman and Perry. Allowing deviations by a pool of “nearby” types, the LCT gives consistent solutions for any positive, though not necessarily perfect, correlation between the signal sender’s true types (e.g., signaling cost) and the value to the signal receiver (e.g., marginal product). It also avoids ruling out reasonable pooling equilibria when separating equilibria do not make sense. We identify conditions for the LCT to be satisfied in equilibrium for both the finite type case and the continuous type case, and demonstrate that the results are identical as we take the limit of the finite type case. We then apply the characterization results to the Spence education signaling model and the Milgrom and Roberts advertising signaling model. Intuitively, the conditions for a separating equilibrium to survive our LCT test require that a measure of signaling “effectiveness” is sufficiently high for every type and that the type distribution is not tilted upwards too much.

*UCLA, UCLA, and Ohio State University. We would like to thank In-Koo Cho, David Cooper, Massimo Morelli, James Peck, and seminar participants at Arizona University, Illinois Workshop on Economic Theory, Ohio State University, Penn State University, Rutgers University, UC Riverside, UC Santa Barbara, and Case Western Reserve University, for helpful comments and suggestions. All remaining errors are our own.

1. Introduction

Since the seminal work of Cho and Kreps (1987), various refinement concepts have been proposed to rank different equilibria in signaling games in terms of their “reasonableness”. However, the mission is still far from being completed. In many applications, signals are “imperfect” in the sense that there is a positive yet imperfect correlation between the signal sender’s true type (e.g., signaling cost) and the signal receiver’s expected value (which then determines her response), see Riley (2001, 2002). Consider a situation in which two of the sender types have a same signaling cost but quite different values to the receiver. If these two types do not observe their values to the receiver, they are effectively the same type, so the existing refinement concepts, such as the Cho and Kreps Intuitive Criterion, apply in the usual way. However, if these two types do observe their different values to the receiver, then the Intuitive Criterion is unable to rank equilibria. The reason is that if one of the two types likes a deviation, the other also likes it, hence no deviation is credible by a single type. This is highly unsatisfactory because the two cases are observationally equivalent.

The reason for the inconsistent solutions in the above example is that the existing refinement concepts focus on deviations by a single type only and do not consider deviations by a pool of types. Grossman and Perry (1986a,b), in a bargaining context, propose an equilibrium refinement concept strengthening the Cho-Kreps Intuitive criterion to allow pooling deviations. In this paper, in a general signaling model, we weaken slightly the Grossman-Perry Strong Intuitive Criterion, and propose a “Local Credibility Test” (LCT) in which a possible deviation is interpreted as coming from one or more types whose equilibrium actions are nearby. We consider only local pooling deviations, first because they seem to us more natural, second because they have much of the power of global pooling deviations, and third because they are more easily analyzed.

Moreover, the Local Credibility Test does not always rule out pooling equilibria in favor of separating equilibria. We will argue that in some situations separating equilibria seem unreasonable while pooling equilibria can be rather appealing. By allowing pooling deviations, the LCT avoids ruling out pooling equilibria in such situations. Consider a simple two type education-signaling model, in which the high type must take a quite costly signal (e.g., several years of unproductive education) to separate from the low type. Now suppose there is only one low type agent in every 5 million high type agents. In such a situation separation seems highly unreasonable, because without taking the costly signaling action an agent should not be perceived much differently from being the high type. By the LCT, it is easy to see that in any separating equilibrium a pooling deviation to some sufficiently low cost level of the signal is profitable to both types, so no separating equilibrium satisfies the LCT.

The thrust of our analysis is to derive conditions under which there exist equilibria satisfying the LCT. We study a family of continuous type models of which the Spence education signaling and the Milgrom and Roberts advertising signaling are both members. We begin by formulating the concept of the LCT for the finite type models first, since the intuition is easier to present. Then we consider a discretization of the continuous type model, and take the limit as the discretization becomes finer. We characterize conditions under which the Pareto dominant separating equilibrium of the model satisfies the LCT. The required conditions are intuitive. As long as a measure of signaling “effectiveness” is sufficiently high for every type and the type distribution is not tilted upwards too much, the separating equilibrium can survive our LCT test.

In the continuous type case, the set of equilibrium signals is dense so that out-of-equilibrium signals can be only found outside the set of equilibrium signals. However, thinking of the continuous type case as the limiting case of the finite type case with many close types, it is natural to generalize the concept of the LCT to the continuous type. An equilibrium survives the LCT if no deviation-perception pair is credible in the following sense: for any possible deviation signal (on- or off-equilibrium), if it is interpreted as from types of a small neighborhood of the immediate equilibrium type, it is profitable for the types in this neighborhood to deviate to this signal, but unprofitable for types out of this neighborhood to do so. Another way of thinking about this credibility test in the continuous type case is the following. If, for an on-equilibrium signal, there is such a deviation-perception pair, then those nearby types can credibly deviate to the particular on-equilibrium signal by throwing away [pic] amount of money.

We derive conditions under which the LCT is satisfied in equilibrium in the continuous type case. The conditions are exactly the same as in the limiting finite type case. This is satisfactory, because models with continuous types and models with finitely many types are theoretical tools for analyzing the same kind of real world problems. Put differently, it would be highly unsatisfactory if an equilibrium refinement concept applies to one case but not the other, or gives different answers for the two cases.

The paper is structured as follows. The next section uses simple examples to illustrate the basic idea of the LCT. Then Section 3 presents the general signaling model. In Section 4, we formulate the concept of the LCT for the finite type case. Then we derive conditions under which the LCT is satisfied by the Pareto dominant separating equilibrium in a discretized continuous type model as the discretization becomes finer. Section 5 generalizes the formulation of the LCT to the continuous type case, and shows that the conditions for the LCT are exactly the same as in the discrete type case. We discuss an issue of robustness in Section 6. Concluding remarks are in Section 7.

2. Examples

A consultant [pic] has a signaling cost type [pic] and a marginal product of [pic], where [pic] and [pic]. She can signal at level z at a cost of [pic]. We suppose that[pic] so that a higher type has a lower signaling cost. If paid a wage w her payoff is[pic]. In a competitive labor market for consultants, her wage will be her marginal product perceived by the market. Activity z is a potential signal because the marginal cost of signaling, [pic], is a decreasing function of [pic]. The set of signaling cost types is[pic], and the set of possible productivity levels is [pic]. The probability of each type, [pic], is common knowledge.[1]

Initially we assume that each consultant observes her own signaling cost type but not her productivity. We define [pic], and assume that types with lower signaling costs have higher expected productivity , that is, [pic].

There is a continuum of separating Nash equilibria in this game. A Nash separating equilibrium with three signaling cost types is depicted below. Each curve is an indifference curve for some signaling cost type. A less heavy curve indicates a lower signaling cost type. Note that the equilibrium choice for each type [pic] (indicated by a shaded dot) is strictly preferred over the choices of the other types. Such an equilibrium fails the Intuitive Criterion first proposed by Cho and Kreps (1987).[2]

To see this, suppose an individual chooses the signal [pic] and argues that she is type [pic]. Is this credible? If the individual is believed, her wage will be bid up to [pic] so she earns the same wage as in the Nash equilibrium but incurs a lower signaling cost. However [pic] is strictly worse than [pic] for type [pic] and strictly worse than [pic]for type[pic]. Thus the claim is indeed credible.

Similar arguments rule out any Nash equilibrium where different signaling cost types are pooled. Thus the only equilibrium that satisfies the Intuitive Criterion is the Pareto dominant separating equilibrium (i.e., the Riley outcome) in which each “local upward constraint” is binding.

Next suppose that each consultant knows both her signaling cost type and her marginal product. Again consider the Nash Equilibrium depicted above. Suppose in this equilibrium three different types are pooled at each signal level. Consider the three types [pic] pooled at [pic]. Suppose a consultant chooses [pic]and claims to be type [pic]. Is this credible? If the claim is believed, the consultant’s wage will rise from [pic] to [pic] thus the consultant is indeed better off. But any offer that makes type [pic] better off also make types [pic] better off, since they have the same signaling cost. Thus there is no credible claim that type [pic] alone can make. A similar argument holds for each of the other types. Thus any Nash separating equilibrium satisfies the Intuitive Criterion. An almost identical argument establishes that any Nash Equilibrium with (partial) pooling satisfies the Intuitive Criterion as well.[3]

Since all the types with the same signaling cost are observationally equivalent, it seems to us that any argument for ranking the equilibria in the first model (productivity unknown) should also be applicable to the second model as well. There is a simple modification to the Intuitive Criterion that achieves this goal. A consultant takes an out-of-equilibrium action [pic]and argues that she is one of the types who, in the Nash Equilibrium would have chosen[pic]. This being the case, applying the Bayes Rule, her expected marginal product is [pic]. Then once again, the unique Nash Equilibriums satisfying the modified Intuitive Criterion is the Pareto Dominant separating equilibrium.

We now argue that for some parameter values, the Pareto Dominant separating equilibrium defies common sense. Consider the following example. Suppose there are two signaling cost types. For those with a high signaling cost ([pic]), the cost of signaling is [pic] with [pic] and [pic], and the mean marginal product is 100. For those with a low signaling cost[pic], the signaling cost is [pic] and the mean marginal product is 200. The Pareto dominant separating equilibrium is depicted below.

The low type must be indifferent between [pic] and the choice of type[pic], that is [pic]. Therefore,

[pic] and so [pic]

The payoff for type [pic] is therefore

[pic].

Suppose that only 1 in 100 consultants is of type[pic]. Then the unconditional mean marginal product is 199. Thus essentially all the social surplus generated by the high types is dissipated by signaling and both types have an income which is approximately half the income that would have in the Nash pooling equilibrium! We believe a better criterion for ranking equilibria should not rule out pooling equilibria in such circumstances. We now introduce a further simple modification of the Intuitive Criterion that achieves this outcome.

Local Credibility Test:

Suppose that an out-of-equilibrium signal [pic] is observed and that [pic] is the largest Nash Equilibrium signal less than [pic] and [pic] is the smallest Nash Equilibrium signal greater than [pic], if they exist. Let [pic] be the subset of signaling cost types choosing [pic] or [pic] with positive probability. For each[pic], define [pic]. Then the equilibrium passes the Local Credibility Test (LCT) if there is no [pic] such that [pic] is strictly preferred over the Nash Equilibrium outcome if and only if [pic].

Note that if [pic] is smaller (greater) than all equilibrium signals, then [pic] ([pic]) does not exist and [pic] ([pic]) is the smallest (largest) equilibrium signal. By the above definition, [pic] is the subset of types choosing [pic] ([pic]). Also note that by considering a subset of [pic] to be the singleton set of a single type choosing [pic]or [pic], the definition of the Local Credibility Test allows deviations by single types. It follows that only separating equilibria can pass the Local Credibility Test.

The idea of the Local Credibility Test is weaker than the Strong Intuitive Criterion (SIC) proposed by Grossman and Perry (1986a,b). For any out-of-equilibrium signal[pic], their criterion considers any subset of types as a potential deviating pool. An equilibrium fails the SIC if [pic] is credible for one subset of types. Here we restrict attention to local deviations. This makes the analysis more tractable and, we believe, more plausible.

Using the idea of the Local Credibility Test, we show that for the simple consulting example above, the Pareto dominant separating Nash Equilibrium is robust to credible pooling deviations. For concreteness, suppose [pic] and [pic]. Then in the Pareto dominant separating equilibrium, [pic] and [pic]. Consider any convex combination [pic]. Then by the definition of the LCT, [pic]. Consider[pic]. The average productivity of these two signaling cost types is 199. For [pic] to be a credible deviation by [pic], both types must strictly prefer[pic]. Note that

[pic] and [pic],

and the equilibrium payoffs are 100 and 101. Thus, for all [pic], both types are indeed better off choosing the out-of-equilibrium [pic]. The Pareto dominant separating Nash Equilibrium thus fails the LCT. In fact no equilibrium passes the LCT, so the criterion fails to rank the different Nash Equilibria.

We now show how the LCT can be applied when there are many types and, in the limit, a continuum of types. Let the set of signaling cost types be [pic], with probabilities [pic] where [pic]. Suppose type [pic] has a signaling cost [pic]. We also assume that the expected marginal product of those of type [pic] have an expected marginal product of [pic].

We seek conditions under which the Pareto dominant separating equilibrium passes the LCT. In this equilibrium, the local upward constraints are binding. Therefore, as depicted below, those with signaling cost type [pic] are indifferent between [pic]. (The indifference curve is labeled [pic].) We construct the signal levels [pic] and [pic] as follows. Choose [pic] so that those with signal type [pic] are indifferent between [pic]. In the Figure below, these are the points [pic].

Then choose [pic] so that those with signal cost type [pic] are indifferent between [pic] and [pic].

In Figure 2.3, these are the points [pic]. We will argue that type [pic] must be indifferent between [pic] as depicted. That is, [pic] is the efficient separating contract for those with signaling cost type[pic].

A type [pic] consultant is indifferent between [pic] if and only if

[pic],

that is, if

[pic] (2.1)

By construction, a type [pic] consultant is indifferent between [pic] and [pic]. Appealing to (2.1),

[pic]. (2.2)

Also, a type [pic] consultant is indifferent between [pic]. Again appealing to (2.1),

[pic]. (2.3)

Adding equations (2.2) and (2.3) and noting that, by hypothesis, [pic], it follows that

[pic].

Appealing, finally, to (2.1), it follows that type [pic] is indeed indifferent between [pic]. Thus the point [pic] is the Pareto dominant separating Nash Equilibrium contract for type[pic].

Note that for any wage [pic] above[pic], there is a signal [pic] between [pic] and [pic] that is strictly preferred by those with signaling cost type [pic] but is not preferred by type [pic] (or lower types). If [pic], the expected marginal product of these two types, [pic] exceeds [pic] and, we can choose [pic] to be equal to the expected marginal product. Then if types [pic] and [pic] choose the out-of-equilibrium signal [pic], they can expect to be paid [pic]. The out-of-equilibrium signal is therefore credible and so the separating equilibrium fails the LCT. Conversely if[pic], the expected marginal product of these two types is less than [pic], the out-of-equilibrium signal [pic] by the two types is not credible. If this holds for all i, that is [pic], the Pareto dominant separating equilibrium passes the LCT.

Note that this condition is independent of the step size [pic] between signaling cost types. Treating the continuum of types in the limit as [pic], it follows that the Pareto dominant separating equilibrium passes the LCT if the density function [pic] is everywhere decreasing.

3. A General Signaling Model

We consider the following signaling environment. A player, the sender, has private information denoted by[pic]. The sender’s (multidimensional) private information affects her expected payoff through an aggregated variable called her “true type” (e.g., marginal cost of signaling). Let [pic] be the true type of the signal sender. The sender chooses an action (signal),[pic], where [pic] is the set of feasible signals.

Let [pic] be the value of the sender’s product or service to a receiver. We assume that the receiver’s payoff is linear in [pic] so that it is only the perceived expected value [pic] which determines the receiver’s response. We can then write the sender’s payoff as a function [pic] of her true type, the receiver’s expected value and the sender’s signal. When the sender’s private information [pic] is multidimensional, it is natural that the sender and the receiver may have similar preferences over[pic], but place different weights on its different dimensions. In other words, the sender’s true type [pic] and the receiver’s value v will be correlated, but not perfectly correlated.

Let [pic] be a strictly monotone signaling function that fully reveals the true type of the sender. Accordingly, [pic] is the utility of the sender of true type [pic] in a separating equilibrium with the signaling schedule[pic], where [pic].

We maintain the following standard assumptions:

(a) [pic]is third order differentiable in all its elements;

(b)[pic];

(c) The single crossing condition holds:

[pic]

Under these assumptions, the standard result in the literature (Riley, 1979; Mailath, 1987) shows that a separating equilibrium of the signaling game satisfies the following differential equation:

[pic] (2.4)

In many signaling models, the signal is costly so that [pic] for all[pic]. In this paper we make this assumption, and discuss what happens when this assumption is relaxed. Naturally, in a separating equilibrium the lowest type[pic] gains nothing to choose any costly signal, so should just choose the least costly signal[pic]. The signaling schedule given by (2.4) and the initial condition [pic] give rise to the unique Pareto dominant separating equilibrium of the game.

This formulation of the signaling problem is quite general and includes many signaling models studied in the existing literature as special cases. We illustrate this with two examples.[4]

Example 1: The Spence education signaling model

In the Spence education signaling model, a worker knows her own personal characteristics related to productivity [pic] (e.g., technical knowledge, discipline, learning ability, work habits, etc). These characteristics can be summarized into a single dimensional variable: productivity, denoted by[pic]. Then a worker’s expected payoff is [pic], where [pic] is her productivity unknown to firms, [pic] is her productivity perceived by firms and hence is also the wage offered to her by competing firms, and [pic]is the education signal the worker can choose. It is typically assumed that for all [pic], (i)[pic]; (ii) [pic]; and (iii) [pic]. It can be easily verified that the single crossing and all other conditions are satisfied. By the standard result, a separating equilibrium satisfies

[pic]

In the Pareto dominant separating equilibrium, the lowest type chooses the minimum education level[pic].

Example 2: An advertising signaling model

This example is adopted from Milgrom and Roberts (1986). A monopolistic firm can produce a good with a constant marginal cost [pic]. It sells to a unit mass of consumers. The firm knows its product quality, denoted by [pic]. Among the consumers, [pic] are informed about [pic]. The rest [pic] of consumers are uninformed about [pic], and their belief is given by the distribution [pic] on [pic]. For products of quality [pic], the consumers’ inverse demand function is [pic], where [pic] is a positive parameter and [pic] is the quantity. So, given price[pic], the demand of an informed consumer is [pic], and that of an uninformed consumer is [pic], where [pic] is his perception of [pic]. The total demand is then[pic].

Suppose the firm spends [pic] on advertising, which leads to a perception of [pic] by the uninformed consumers. By choosing an optimal price given [pic], the firm’s maximum profit is [pic]. Consider a possible separating signaling schedule [pic]. The firm’s payoff function is

[pic]

It can be checked that this example fits the general model as well. A separating equilibrium satisfies

[pic]

In the Pareto dominant separating equilibrium, the lowest type chooses zero advertising.

4. Finite Type Case

In this section we explore conditions under which an equilibrium satisfies the LCT in the finite type case.

Specifically, the sender has [pic] true types, denoted by [pic]. Let [pic] be the probability distribution of the sender’s true type. Let [pic] be the receiver’s perception of the sender’s type. The sender’s expected payoff is [pic] , which satisfies all the assumptions made in Section 2.

Let [pic], where [pic], be an equilibrium signaling schedule. Consider any signal[pic].

(L1): No credible deviation by the lowest type

When[pic], [pic] is a credible deviation if[pic].

(L2): No credible deviation by the highest type

When[pic], [pic] is a credible deviation if [pic].

(L3): No local pooling deviation

Define[pic]. When [pic], [pic] is a credible deviation if [pic] and [pic].

(L4): No local deviation by a single type

When[pic], for [pic], [pic] is a credible deviation if [pic][pic] and, [pic].

By the definition of the Local Credibility Test given in Section 2, if there does not exist any kind of credible out-of-equilibrium signal-perception, then the equilibrium [pic] survives the LCT.

We say that an equilibrium “satisfies” a requirement among (L1)-(L4) if there is no such credible deviation described in the requirement. Requirements (L1), (L2) and (L4) are all about deviations of one single type, which are the local conditions of the Cho-Kreps Intuitive Criterion. When[pic], they are exactly the Cho-Kreps Intuitive Criterion. Requirement (L3) is the local condition of the Grossman and Perry criterion, allowing a deviation to be interpreted as from the two nearby types.

By the argument similar to the Cho-Kreps’ Intuitive Criterion, it can be shown that if an equilibrium satisfies the LCT, it is the Pareto dominant separating equilibrium (the Riley outcome). Therefore, to check when an equilibrium satisfies the LCT, we only need to check when the Pareto dominant separating equilibrium satisfies (L3). Consider the Pareto dominant separating equilibrium depicted in Figure 4.1 below.

Figure 4.1

For any interior point [pic] with [pic], define[pic] be the intercept of indifference curves [pic]and [pic]depicted in Figure 4.1. Then

[pic] (4.1)

Let [pic] be the average type of[pic], that is,

[pic] (4.2)

For the lower boundary point [pic], define [pic] as the solution to the following equation: [pic]. The point [pic] is depicted in Figure 4.2 below.

Figure 4.2

The expected type between [pic] and [pic] is [pic].

Proposition 1: The Pareto dominant separating equilibrium satisfies the LCT if and only if for all [pic], [pic].

Proof: Note that only points in the shaded areas in Figures 4.1 and 4.2 are preferred by both types of[pic] ([pic]and [pic]) to their respective equilibrium points. If [pic], then there is no signal between [pic] ([pic] and [pic]) to which both types of[pic] ([pic] and [pic]) are willing to deviate if the receiver has the perception of [pic]. So the LCT is satisfied. On the other hand, if the LCT is satisfied, then it must be the case that [pic]. Otherwise, it is clear from Figures 4.1 and 4.2 that there are signals that both types of[pic] ([pic]and [pic]) are willing to deviate to but other types do not. Q.E.D

The idea of Proposition 1 is simple. For both interior points and boundary points, [pic] is the minimum perception by the receiver such that the two types [pic] and [pic] can find a common profitable deviation that is not attractive to any other types. The receiver’s correct perception about the pool of [pic] and [pic] is [pic]. If [pic] for all [pic], then no pair of types can find a local pooled deviation such that under the correct perception by the receiver, it is profitable only to them but not any other type. If that is the case, the LCT is satisfied by the Pareto dominant separating equilibrium.

Proposition 1 can be used to check the existence of equilibrium satisfying the LCT in any finite type model. Let us return to the continuous type signaling model introduced in Section 2 in which the type space is [pic] with a smooth distribution function [pic]. We study the following discrete type version where [pic] [pic] and [pic]. We let [pic] for[pic], that is, as [pic] increases by one, each interval is divided into two even ones. We are interested in the limit case when [pic], or [pic], as an approximation of the continuous type case.

To simplify our analysis, we make the following technical assumptions, though these assumptions are not necessary for the general idea of our LCT to work.

B1: [pic] for all [pic];

B2: [pic] for all [pic].

It is easy to check that the Spence education signaling model satisfies both conditions, but the advertising signaling model does not. However, in the next Section, we will show that our method can be easily applied to the advertising signaling model to get similar characterization results.

Consider interior types first. For any [pic] and [pic], fix [pic]. As [pic] increases, let [pic] be the nearest types to [pic], so [pic] and [pic]. Let [pic], and [pic] be the solution to (4.1)

Lemma 1: When[pic], (i) [pic]; (ii) [pic]; (iii) [pic].

Proof: See the Appendix.

Lemma 2: Suppose conditions B1 and B2 hold. When [pic], (i) [pic]; (ii) [pic]; (iii) [pic].

Proof: See the Appendix.

[pic]

For the boundary type[pic], let [pic] be the solution to [pic] [pic], where [pic] is such that [pic]. Let [pic] be [pic]. Note that if[pic], then [pic] for all [pic], which means that [pic] and hence the condition of Proposition 1 is violated. However, in the discrete type case,[pic] means that[pic] should not be considered at all. Thus, we suppose [pic]. We have

Lemma 3: Suppose conditions B1 and B2 hold. When [pic], (i) [pic], [pic], and [pic]; (ii) [pic], [pic], and [pic].

Proof: See the Appendix.

From Lemmas 1-3, we have our main characterization result for the limiting discrete type case.

Theorem 1: Suppose conditions B1 and B2 hold. When [pic], the Pareto dominant separating equilibrium of the discrete type model satisfies the LCT if

i) for any [pic],

[pic] (4.3)

(ii) [pic] and [pic]. (4.4)

The intuition for Theorem 1 is easy to understand. Consider the consulting example discussed in Section 2, where we showed that one reason for non-existence is that the type distribution is tilted upwards too much. Another reason for non-existence is how the different curves differ across types. Since the marginal rate of substitution between signal [pic] and perception [pic] is similar for the different types in that example, the indifference maps are similar and so indifference curves are close together. As a result, both types are better off deviating to [pic] if the receiver believes that both may be choosing to deviate, thus violating the requirement of no credible deviation. However, if the marginal rate of substitution declines sufficiently rapidly with type, the indifference curve[pic] in Figure 4.1 will be everywhere above[pic], the average type. Now only type [pic] is better off deviating to [pic] if the receiver still thinks that both types may be deviating, making the deviation-perception pair not credible.

Intuitively, the rate at which the marginal rate of substitution declines with [pic] is a measure of signaling effectiveness. Thus Theorem 1 suggests that when signaling effectiveness is sufficiently large, the separating equilibrium will survive the LCT. This intuition is reflected in conditions (4.3) and (4.4). Note that the slope of the indifference map is given by[pic], and by Assumption B1, [pic] . The LHS of (4.4) can be rewritten as [pic], which measures how rapidly the MRS declines with [pic] at [pic] (normalized at the level of MRS itself). Figuratively, when the LHS is greater, the indifference curve [pic] is far from [pic] in Figure 4.1, hence there will be no credible deviation with the perception at [pic]. The RHS of (4.4) is the density function of [pic], normalized by the probability mass at [pic]. Clearly, the smaller this ratio, the smaller the perception of a pool involving[pic]. When the expected value of the two types, [pic], is lower in Figure 4.1, there will be no credible deviation.

The intuition for (4.3) is similar, though less transparent. The last term of the LHS (over the denominator), [pic], has exactly the same interpretation: a measure of how rapidly the MRS declines with [pic]. From Figure 4.1., the critical value of [pic]depends on how rapidly the curve [pic] increases with [pic] and how slowly the curve [pic] increases with [pic]. Note that [pic] by Assumption B2 and [pic]. The first and third terms in (4.3) can be rewritten as

[pic]

Figuratively, when the curve [pic] is more straight-up (large [pic]) and the curve [pic]is more flat (small [pic]), there will be no credible deviation with the perception at [pic]. The RHS of (4.3) is the concavity of the distribution function of [pic],[pic], normalized by its density function. Intuitively, the more concave [pic]is (i.e., the smaller [pic]is), the more probability mass on smaller[pic] in any set of types, thus the smaller the expected value of any set of types. Consequently, the smaller [pic]is, the less likely a deviation is credible.

In summary, Theorem 1 says that the Pareto dominant separating equilibrium will satisfy the LCT if signals are effective in distinguishing types (i.e., MRS declining fast with types) and the type distribution is not too tilted upwards.

5. Continuous Type Case

In this section we derive conditions under which an equilibrium satisfies the LCT in the continuous type case. We show that the results here are exactly the same as those in the limiting discrete type case studied in the preceding section.

As in the discrete type case, we can focus on separating equilibria. Consider any separating equilibrium [pic]. Consider any signal[pic].

(L1): When[pic], [pic] is a credible deviation if [pic].

(L2): When[pic], [pic] is a credible deviation if [pic].

(L3c): When[pic], let [pic] and consider a small neighborhood of [pic],[pic].

Let [pic]. If

[pic].

[pic].

Then the signal-perception [pic] is credible.

By the definition of the Local Credibility Test given in Section 2, if there does not exist any credible signal-perception, then the separating equilibrium [pic] survives the LCT.

Requirements (L1) and (L2) are exactly the same as in the finite type case. In the continuous type case, the results of Riley (1979) and Mailath (1987) show that there is a unique separating equilibrium if the lowest type sender chooses the signal that is optimal under complete information. It is easy to see that this Pareto dominant separating equilibrium is the only equilibrium that satisfies (L1) and (L2). Therefore, to check whether there exists an equilibrium satisfying the LCT, we only need to check whether this equilibrium satisfies Requirement (L3c).

Requirement (L3c) is the counterpart of (L3) in the discrete case. In the continuous type case, any signal [pic] is “on-equilibrium,” so Requirement (L4) in the discrete case does not apply. However, thinking of the continuous type case as the limit of the discrete type case with many very close types, it is easy to understand how an “on-equilibrium” signal can be alternatively interpreted as a deviation signal and how to check credibility of such deviations. Consider any “on-equilibrium” signal[pic], and suppose the type of sender for this signal in the separating equilibrium is[pic]. Suppose in a discrete type version of the model, [pic] for some [pic]. Suppose the nearby types [pic]all deviate to this signal, and this is correctly perceived by the receiver and so the perception of the average type is [pic]. Requirement (L3c) says that if given the perception [pic], all the deviating types can gain relative to their equilibrium payoffs while all other types cannot, then those nearby types can credibly deviate to the particular “on-equilibrium” signal. If a separating equilibrium does not allow any such credible deviations, then it satisfies the LCT. As mentioned in the Introduction, another way of thinking about on-equilibrium deviations is as follows. If for an on-equilibrium signal there is such a deviation-perception pair [pic] as described in (L3c), then those nearby types can credibly deviate to [pic] by throwing away a small amount of money. Since other types will not gain by mimicking, throwing away money by types in[pic]can signal to the receiver that they are the types deviating to[pic].

Since the continuous type case is viewed as an approximation of the case of many close discrete types, we only need to check whether there are any credible interior deviations and any credible boundary deviations for very small intervals, in the sense that will be made precise below.

Consider interior deviations first. For any two types [pic], suppose those in the interval [pic] pool at a certain signal[pic]. Let [pic] be the expected type of this pool: [pic]. Let [pic] and [pic] be a solution to

[pic] (5.1)

The point [pic] is depicted below in Figure 5.1. Given this signal-perception pair, all those types in [pic] prefer the pool to their separating equilibrium payoff.

The types in [pic] cannot find a credible deviation defined in (L3c) if and only if the signal-perception pair of [pic] is not credible. Therefore, the separating equilibrium [pic] satisfies (L3c) only if for any [pic] and [pic], [pic] as [pic]. Note that for any[pic], [pic]. Furthermore, we have

Lemma 4: For any [pic], (i) [pic]; (ii) [pic].

Proof: See the Appendix.

Lemma 5: Suppose conditions B1 and B2 hold. For any [pic] such that [pic], (i) [pic]; (ii) [pic]

Proof: See the Appendix.

We now consider the boundary deviations of the following kind. For any type [pic], suppose those in the interval [pic] all choose [pic], the equilibrium signal by [pic]. Let [pic] be the expected type of this pool. Suppose [pic], we have

[pic] (5.2)

Let [pic] be a solution to

[pic] (5.3)

In order for the separating equilibrium characterized by [pic] to satisfy the LCT, it must be that for [pic] close to [pic], any such signal-perception pair of [pic] is not credible. That is, [pic] as [pic]. Note that [pic].

Lemma 6: Suppose conditions B1 and B2 hold. (i) Suppose [pic]. Then, [pic], [pic]; (ii) [pic], and [pic].

Proof: See the Appendix.

Theorem 2 below follows immediately from Lemmas 4 to 6.

Theorem 2: Suppose conditions B1 and B2 hold. The Pareto dominant separating equilibrium [pic] in the continuous type model satisfies the LCT if

(i) for any [pic],

[pic] (5.4)

(ii) [pic] and [pic]. (5.5)

Therefore, Theorems 1 and 2 show that the concept of the LCT can be applied to the continuous type model exactly as in the discrete type model. While the continuous type model is easier to work with analytically in terms of charactering the separating equilibrium, it should be viewed as an approximation of the situation with many close discrete types. Our position is that it should be subject to the same scrutiny of credibility as discrete type models, even though signals are literally “on-equilibrium” in the continuous type model. The equivalence of Theorems 1 and 2 demonstrates that this approach is valid.

We want to make several remarks about the condition that[pic]. Note that when[pic], it can be shown that as[pic], [pic]. By Lemma 6, in the neighborhood of[pic], [pic], hence there is always a credible boundary deviation at the lowest signal[pic]. Thus, the condition [pic] is necessary for the LCT. This condition is completely natural in the discrete type case. Viewing the continuous type case as an approximation of the discrete type case, we can think of this condition as requiring that smoothing out the probability masses of all other types except for type[pic].

Another way of justifying [pic] is as follows. Imagine that for some participation costs not modeled here, there are some types slightly lower than [pic] who do not actively participate in the market. As can be seen from Figure 4.2, while those types do not find the signal-perception pair[pic] attractive, they may well find the signal-perception pair [pic] profitable and thus would like to join the pooling deviation. Thus, when we consider a possible boundary deviation, the existence of these types slightly lower than [pic] will affect the perception of the receiver as if there were an equivalently probability mass on [pic].

Below we apply our results to the education signaling and the advertising signaling examples introduced above.

Example 1 (continued): The Spence education signaling model

Since [pic] the assumptions B1 and B2 are both satisfied. In the common formulation of the model, [pic] for all [pic].

Since [pic] and [pic], condition (5.4) becomes

[pic]

where all derivatives are evaluated at [pic]. Condition (5.5) is simply that [pic] and [pic]. When these conditions hold, then the Pareto dominant separating equilibrium satisfies the LCT. In a simply case with[pic], where [pic] measures how fast marginal cost of education [pic]decreases in type [pic] and[pic] is a positive constant, the intuition of the conditions is very clear. The LCT will be satisfied if the signal effectiveness measured by the marginal rate of substitution [pic] is large and the type distribution is not tilted upward too much. Clearly, the greater [pic] is, the more likely the LCT is satisfied.

Example 2 (continued): The advertising signaling model

From the firm’s payoff function, we have[pic] and [pic]. Since this model does not satisfy the assumptions B1 and B2, we cannot apply Theorem 2 directly. However, using the same method, it is not difficult to derive conditions under which the LCT is satisfied. We have the following result.

Proposition 2: In the advertising signaling model, the Pareto dominant separating equilibrium satisfies the LCT if (i) [pic] for [pic], and (ii) [pic] and [pic].

Proof: See the Appendix.

Because of the quadratic function form of the firm’s payoff function and other special features of this model (e.g., many cross derivatives are zero), the measure of signal effectiveness is constant and equals zero. So for the condition of no credible interior deviations, it all depends on the type distribution. Proposition 2 also says that for the boundary deviations not to be credible, the proportion of informed consumers must be relatively large. This is intuitive. Since informed consumers will not be fooled by deviations in advertising, more of informed consumers reduces the incentives to deviate and makes the separating equilibrium more likely to satisfy the LCT.

A special case commonly studied in applications is when the type is uniformly distributed. Then[pic]for[pic]. It can be shown that as[pic], all higher order partial derivatives of [pic] and [pic] with respect to[pic]are zero, which implies that in the limit, [pic]. So this is really a knife edge case. By our definition, however, the LCT is not satisfied.

6. Interior Optimum for the Lowest Type

So far we have assumed that [pic] for all[pic]. When the signal is partially productive, this assumption may not hold. Then the perfect information optimal choice for the lowest type, [pic], may be an interior optimal solution, which implies that [pic]. In this case, Theorems 1 and 2 do not hold any more. To illustrate the problem, consider the following example.

Example 3: The price signaling model

This example is also adopted from Milgrom and Roberts (1986). The environment is identical to that in the advertising signaling model, except that the firm uses prices rather than advertising to signal its quality. Suppose the firm chooses price[pic], which leads to a perception of [pic] by the uninformed consumers. Then the firm’s profit is [pic]. Consider a possible separating signaling schedule[pic]. The firm’s payoff function is

[pic]

It can be checked that this model satisfies the standard assumptions and assumptions B1 and B2. By the standard result, a separating equilibrium satisfies

[pic]

However, for the lowest type, the full information optimal price is chosen so that [pic], which gives [pic]. To check interior deviations, for[pic], condition (5.4) becomes:

[pic] (6.1)

For [pic] close to[pic], it can be checked that the nominator on the LHS is negative, hence the LHS goes to negative infinity. This shows that the Pareto dominant separating equilibrium fails the LCT around the lower boundary point.

The above “lower endpoint” problem can be overcome if we modify the model so that there is a significant fixed cost to enter the market. If the fixed cost is greater than the maximum profit the lowest type can get, the lowest type and all the types lower than a certain threshold will stay out of the market. Then for the lowest type that does enter the market, it cannot choose its complete information optimal price. Otherwise, some of the lower types would find it profitable entering the market mimicking it. With this type of truncation of the type distribution by entry costs, it is again the case that [pic] for all the types signaling in the market so Theorem 2 applies.

7. Concluding Remarks

Except in the special case of perfect correlation between the sender’s true type and the value to the signal receiver, standard refinements (Intuitive Criterion, Divinity, Stability) are not applicable. We argue that to have any “bite” at all, a refinement is needed in which the signal receivers take into account the way sender types are distributed. We then propose a Local Credibility Test which is somewhat stronger than the Cho and Kreps Intuitive Criterion but milder than the Grossman-Perry Criterion.   For a class of models which includes the Spence education signaling model and the advertising signaling model, we provide conditions under which the Pareto dominant separating equilibrium satisfies the LCT. These conditions are the more likely to be met, (a) the less rapidly the density increases or the more rapidly the density decreases with type, and (b) the more rapidly the marginal cost of signaling decreases with type. 

What is the “right” equilibrium when our conditions are not met? This is a challenging question for which we have no satisfactory answer.  As can be seen from the simple two-type model depicted in Figure 2.2, our LCT test and the even stronger Grossman and Perry SIC show that the Pareto dominant separating equilibrium is not reasonable. But at the same time, all other equilibria are “killed” as well.

We conjecture that pooling or partial pooling must be a part of any more complete analysis of signaling.  To make the point as starkly as possible, let [pic]be the probability that a sender is low type. With[pic], the high type does not have to signal at all. As long as [pic] is positive, the high type has to take costly signaling to separate herself from the low type. Thus the separating equilibrium has an extreme discontinuity at [pic]. When [pic]is close to zero, the pooling outcome seems more reasonable than the highly inefficient separating equilibrium. That is, “reasonable” out-of-equilibrium beliefs do not necessarily lead to reasonable outcomes.

Appendix A: Proofs

Proof of Lemma 1: Using[pic], we rewrite (4.2) as follows:

[pic]

Differentiating with respect to [pic] on both sides, we have

[pic]

[pic]

[pic]

Letting [pic] we obtain: [pic]. Q.E.D

Proof of Lemma 2: First by the continuity of [pic] we have [pic] from (4.1). Differentiating (4.1) with respect to[pic], we have

[pic] (8.1)

[pic] (8.2)

[pic] (8.3)

To save on notation, let [pic]. From (8.3) we have

[pic] (8.4)

We can obtain the higher order derivatives for [pic]:

[pic] (8.5)

[pic] (8.6)

where [pic].

Write [pic] and [pic]. From (8.1) and (8.2) we have

[pic] and [pic] where (8.7)

[pic]

[pic] [pic]

Differentiating the above equations, and using B1, B2 and (8.4) - (8.6), we can derive the following derivatives evaluated at [pic]:

[pic]

[pic]

[pic]

[pic][pic]

[pic]

Using L’Hopital’s rule, we have

[pic]

which implies [pic] and [pic]. Taking second order derivatives, we have

[pic]

[pic]

Using L’Hospital’s rule again we have

[pic] (8.8)

Substituting the expressions of [pic] derived above into (8.8), we can solve for values of [pic] as follows:

[pic] Q.E.D.

Proof of Lemma 3: In Figure 4.2, the following conditions hold:

[pic] (8.9)

The expected type of [pic] and [pic] is

[pic] (8.10)

Obviously when [pic], we have [pic]. Multiplying [pic] on both sides of (8.10), and differentiating with respect to [pic], we have

[pic] (8.11)

Letting [pic] we have [pic] as [pic]. Now differentiating (8.11) once more and letting [pic], we obtain

[pic]

From (8.9) we first have [pic] by the continuity of [pic]. Differentiating (8.9) with respect to [pic], and denote [pic] and [pic], we have

[pic] (8.12)

Letting [pic] we have [pic] as [pic]. Differentiating (8.12) once more and evaluating at [pic] we obtain

[pic] Q.E.D.

Proof of Lemma 4: By definition,[pic]. Multiplying both sides by [pic] and then differentiating by[pic], we have

[pic].

Differentiating by [pic]again,

[pic] (8.13)

Setting [pic], it follows immediately that [pic].

Differentiating (8.13) by [pic] again,

[pic]Since [pic] and [pic], setting [pic] we obtain[pic]. Q.E.D.

Proof of Lemma 5: Total differentiating (5.1) gives

[pic]

Solving the equations, we have

[pic]

[pic]

Under Assumption B1, we have

[pic] (8.14)

[pic] It must be that [pic]. For the simplicity of notation, write [pic]. Applying the I’Hopital’s rule, [pic]we get

[pic]

Hence [pic][pic] as long as [pic] is defined at [pic], or [pic] at [pic].

Since

[pic] (8.15)

we have

[pic]

for any [pic] such that [pic]. This proves part (i). For part (ii), first note that from [pic],

[pic]

From (8.14), and by Assumption B1, we have

[pic]

[pic] (8.16)

Let[pic] be the ith term on the right hand side of the above equation. For any [pic] such that [pic], it can be checked that

[pic]

Therefore,

[pic]

From (8.15), and using Assumption B2, we have

[pic] (8.17)

[pic]we know that [pic] and[pic]. So,

[pic]

This proves part (ii). Q.E.D.

Proof of Lemma 6: Multiplying both sides in (5.2) by [pic] and then differentiating by[pic], we have

[pic]

Differentiating by [pic]again, we have

[pic]

Setting [pic] in the two equations above, we prove (i). Total differentiating (5.3) gives

[pic]

Total differentiating once more gives

[pic]

Taking limits in the two equations above, we get (ii). Q.E.D.

Proof of Proposition 2: We consider the interior deviation first. Following the same notation as in the main text of our paper, we have

[pic] (8.18)

Using L’Hospital’s rule, we have [pic], which implies [pic] Differentiating (8.18) with respect to [pic], we have

[pic] (8.19)

Using L’Hospital’s rule again, we have

[pic]

which implies [pic]. Therefore, there is no credible interior deviation if [pic], or if [pic] is strictly concave.

Next consider lower endpoint deviation. From Figure 4.2 in the text, we have

[pic]

Differentiating with respect to [pic] we have

[pic] (8.20)

Letting [pic], we have [pic]. Differentiating (8.20) once more time and letting [pic], we have

[pic]

Therefore, there is no lower endpoint deviation if [pic] and [pic]. Q.E.D.

Appendix B: Application to the reserve price signaling model

Cai, Riley and Ye (2003) and Jullien and Mariotti (2003) study the following reserve price signaling model in auction settings. A seller of an indivisible good has private information about certain characteristics of the good that the potential bidders do not know. Let [pic] be the seller’s information. The seller’s own valuation of the good is [pic], and the common value component of the bidders’ valuations is [pic], where [pic] is a positive parameter. Bidder [pic]’s valuation is [pic], where[pic] is the private value component that is known to himself only. The bidders’ private signals [pic] are i.i.d. random variables with a distribution function [pic] and an everywhere positive density function[pic]. Suppose the seller uses a sealed bid second price auction to sell the good; and she sets a reserve price [pic]. Let [pic] be the perceived type of the seller, i.e., the perceived common value component in bidders’ valuations. Using a variable transformation by defining the reserve markup [pic], Cai, Riley and Ye (2003) show that the seller’s expected payoff can be expressed as

[pic]

where [pic] is the distribution function of the first order statistics and [pic] . Thus the model fits into the standard signaling framework.[5]

To fit this into our signaling model, we adopt another variable transformation: [pic], and let [pic]. Then the seller’s expected payoff is

[pic]

It can be verified that

[pic]

where[pic] that is assumed to be strictly increasing in [pic].

With this transformation, the derivatives of [pic] are

[pic]

The standard assumptions and B1 and B2 are all satisfied. By the standard results, a separating equilibrium satisfies

[pic]

We now analyze when this separating equilibrium satisfies the conditions of Theorem 2. We focus on the special case[pic]. Suppose [pic] so that the separating equilibrium goes through [pic] at [pic]. Since [pic] [pic] is decreasing in[pic], [pic] for all [pic].

In this model, since[pic], condition (5.4) becomes

[pic],

Condition (5.5) requires that [pic] and [pic].

References

Cai, Hongbin, John Riley and Lixin Ye (2003), “Reserve Price Signaling,” Working Paper, UCLA.

Cho, In-Koo and Kreps, David M. (1987), “Signaling Games and Stable Equilibria,” Quarterly Journal of Economics, 102, 179-221.

Cho, In-Koo and Sobel, Joel (1990), “Strategic Stability and Uniqueness in Signaling Games,” Journal of Economic Theory, 50, 381-413.

Grossman, Sanford and Perry, Motty (1986a), “Sequential bargaining under Asymmetric Information,” Journal of Economic Theory, 39, 120-154.

Grossman, Sanford J. and Perry, Motty (1986b), “Perfect Sequential Equilibrium,” Journal of Economic Theory, 39, 97-119.

Jullien, B. and Mariotti, T. (2003), “Auction and the Informed Seller Problem,” University of Toulouse Working Paper.

Kohlberg, Elon and Mertens, Jean-Franqis (1986), “On the Strategic Stability of Equilibria,” Econometrica, 54, 1003-1037.

Mailath, George (1987), “Incentive Compatibility in Signaling Games with a Continuum of Types,” Econometrica, 55:1349-1365.

Milgrom, Paul and Roberts, John (1986), “Price and Advertising Signals of Product Quality,” Journal of Political Economy, 94:796-821.

Myerson, Roger B. (1981), “Optimal Auction Design,” Mathematics of Operations Research, 6, 58-73.

Ramey, Garey (1996), “D1 Signaling Equilibria with Multiple Signals and a Continuum of Types,” Journal of Economic Theory, 69, 508-531.

Riley, John (1975), “Competitive Signaling,” Journal of Economic Theory, 10, 174-186.

Riley, John G. (1979), “Informational Equilibrium,” Econometrica, 47, 331-359.

Riley, John G. (2001), “Silver Signals: 25 years of Screening and Signaling,” Journal of Economic Literature, 39, 432-478.

Riley, John G. “Weak and Strong Signals” (2002) Scandinavian Journal of Economics, 104, 213-236.

Riley, John G. and William F. Samuelson, (1981), “Optimal Auctions,” American Economic Review, 71, 381-392.

Rothschild, Michael and Stiglitz, Joseph (1976), “Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information,” Quarterly Journal of Economics, 90, 629-649.

Spence, A. Michael (1973), “Job Market Signaling,” Quarterly Journal of Economics, 87, 355-379.

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[1] If [pic] for all [pic], the model reduces to the usual Spence model in which the negative correlation between signaling cost and value to receivers is perfect. While we assume [pic] for all [pic], the analysis applies generally.

[2] As noted by Cho and Kreps (1987), with more than two types, it is necessary to modify their original Intuitive Criterion or it loses much of its power. For the modified Intuitive Criterion the question is whether any particular type is uniquely able to benefit from some out-of-equilibrium signal if the signal receivers correctly infer the signaler’s type.

[3] It can be verified that the Cho and Sobel (1990)’s refinement concept of “divinity”, which is built on the idea of stability of Kohlberg and Mertens (1986) and can be considered as a logic offspring of the Intuitive Criterion, does not have power either in the above example. Ramey (1996) extends the Cho and Sobel’s divinity concept to the case of a continuum of types. Like the Intuitive Criterion, divinity faces the same problem of distinguishing types [pic]to interpret a possible deviation, while these types have the same incentives to deviate. Riley (2001) discusses in greater details these and other refinement concepts.

[4] Many other applications fit into the general signaling model. In Appendix B, we show that with some variable transformations, the reserve price signaling model of Cai, Riley and Ye (2003) satisfies all the assumptions. We then apply our characterization results to check when the Pareto dominant separating equilibrium in that model satisfies the LCT.

[5] Cai, Riley and Ye (2003) study a much more general model with affiliated private signals of the bidders and general valuation functions.

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[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

Fig: 2-1: Separating Nash Equilibria

200

100

[pic]

[pic]

[pic]

[pic]

w

Fig. 2.2: Separating equilibrium with a gain of [pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

Fig. 2-3: Applying the LCT with many types

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

[pic]

Fig. 5.1: Pool of types in [pic]

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