Handout 3A - Adverse Selection Akerlofs used car model...

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Adverse Selection Akerlof’s used car model: Buyer does not know the quality of the car, which can be of high quality or low quality. market failure Spence’s signaling model: the employee may be of high productivity (H) or low productivity (L), and they can use education to signal their productivities. separating or pooling equilibrium (all Nash equilibrium) Corporate Finance © Professor Ho-Mou Wu 3A-1 Spring 2004 H M L Buyer
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Signaling Models: Separating Equilibrium Given the wage schedule And the cost of education , , the optimal choice by type H is and by type L, . separating equilibrium Critical condition: the cost of education for high productivity (H) employees is much less than that for low productivity (L) employees. 3A-2 Spring 2004 Corporate Finance © Professor Ho-Mou Wu { * * 1 2 ) ( y y if y y if y W < = H C L C * y y = W 2 1 0 * y education y = L C H C ) ( y W 0 = y
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Signaling Models: Pooling Equilibrium If the cost of education for type H employees is not much different from that for type L employees, they will all choose . pooling equilibrium Models of asymmetric information have many useful applications in corporate finance. 0 = y 3A-3 Spring 2004 Corporate Finance © Professor Ho-Mou Wu education y = * y 0 1 2 W L C H C ) ( y W
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Moral hazard (Moral Hazard) f x¢E¶ 1 (Principal) 0 . (Agent) 0, d 0 d 0 d 0. o (density function) d . (distribution function) d . ð 11D (support) d . Corporate Finance © Professor Ho-Mou Wu 3A-4 Spring 2004 contracting action state outcome s(x) a θ x=x(a , ) θ )) ( ( EV x s x - V 0 V ) ( )) ( ( Eu a g x s - u u g g f ( x M a ) f x β α ) ) , ( ( ) ; ( a θ a x f a x f = 1 ) , ( = dx a x f ) ; ( a x F ) ; ( a x f [ ] β , α
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Complete information ( a is observable) no problem with incentive, only a problem of
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Handout 3A - Adverse Selection Akerlofs used car model...

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