Adverse Selection

Julio Dávila

2009

Julio Dávila Adverse Selection

the planner’s problem

Julio Dávila Adverse Selection

the planner’s problem

1 a continuum of types of workers, indexed by θ ∈ [0, 1]

Julio Dávila Adverse Selection

the planner’s problem

1 a continuum of types of workers, indexed by θ ∈ [0, 1]

2 a worker of type θ produces θ in a firm

Julio Dávila Adverse Selection

the planner’s problem

1 a continuum of types of workers, indexed by θ ∈ [0, 1]

2 a worker of type θ produces θ in a firm
3 a worker of type θ produces r (θ) at home

Julio Dávila Adverse Selection

the planner’s problem

1 a continuum of types of workers, indexed by θ ∈ [0, 1]

2 a worker of type θ produces θ in a firm
3 a worker of type θ produces r (θ) at home

who should work for a firm and who stay home?

Julio Dávila Adverse Selection

the planner’s problem

1 a continuum of types of workers, indexed by θ ∈ [0, 1]

2 a worker of type θ produces θ in a firm
3 a worker of type θ produces r (θ) at home

who should work for a firm and who stay home?

I θ should work for a firm if r (θ) ≤ θ

Julio Dávila Adverse Selection

the planner’s problem

1 a continuum of types of workers, indexed by θ ∈ [0, 1]

2 a worker of type θ produces θ in a firm
3 a worker of type θ produces r (θ) at home

who should work for a firm and who stay home?

I θ should work for a firm if r (θ) ≤ θ
I θ should stay home if r (θ) > θ

Julio Dávila Adverse Selection

two sectors, different productivities

... ..
...
........ θ
... .
....
...
... .
.. .....
... ....
... ........
... ....
... .
.......
... ...
... ...... ................ r (θ)
...
..... ..............................................
.
..
... .........
...
. .........................
.......................... ........
.. ...
... .
.......
... .....
.. ......
. ..
............................................................................................................................
θ

Julio Dávila Adverse Selection

efficient allocation

... ..
...
........ θ
... .
....
...
... ... .....
... ....
... ... .....
... ....
... .
.......
... ...
... .....
. ................ r (θ)
... .
.... ..............................................
.
..
... . .
..........
.
.......................................................
.... ... .
.. .... ..
.... .
....... ..
.. ........ ..
..
.... .......
.................................................∗........................................................................
θ θ

Julio Dávila Adverse Selection

efficient allocation

... ..
...
........ θ
... .
....
...
... ... .....
... ....
... ... .....
... ....
... .
.......
... ...
... .....
. ................ r (θ)
... .
.... ..............................................
.
..
... . .
..........
.
.......................................................
.... ... .
.. .... ..
.... ..
...... ..
.. ........ ..
..
.... .......
.................................................∗........................................................................
home θ firm θ

Julio Dávila Adverse Selection

let w be the offered wage...

... ..
...
........ θ
... .
....
...
... ... .....
... ....
... ... .....
... ....
... .
.......
... ...
... ...... ................ r (θ)
... .
... ..............................................
...
.
. .
...
..................................................................................... w
. ......... ..
.......................... ........ ...
.. ... ..
... .
....... ..
... ..... ..
... ...... ..
...
....................................................∗........................................................................
home θ firm θ

Julio Dávila Adverse Selection

inefficient allocation

... ..
...
........ θ
... .
....
...
... ... .....
... ....
... ... .....
... ....
... .
.......
... ...
... ...... ................ r (θ)
... .
... ..............................................
...
.
. .
...
..................................................................................... w
. ......... ..
.......................... ........ ...
.. ... ..
... .
....... ..
... .... ..
... ......
. ..
...
....................................................∗........................................................................
firm! θ home! θ

Julio Dávila Adverse Selection

unfeasible allocation

... ..
...
........ θ
... .
....
...
... ... .....
... ....
... ... .....
... ....
... .
.......
... ...
... ...... ................ r (θ)
... .
... .............................................
...
.
. .
....
................................................................................................... w
. ......... ..
.......................... ........ ...
.. +...... ..
... .. ..
... ....... ..
... ......
. ..
...
....................................................∗........................................................................
firm! θ home! θ

Julio Dávila Adverse Selection

non rational expectations

... ..
...
........ θ
... .
....
...
... ... .....
... ....
... ... .....
... ....
... .
.......
... ...
... ...... ................ r (θ)
... .
... .............................................
....
. ...
. .
................................................................................................... w
. ......... ..
.......................... ........ ...
.. +...... ..
... .. ....E (θ)
... ....... ..
... ......
. ..
...
....................................................∗........................................................................
firm! θ home! θ

Julio Dávila Adverse Selection

let w be the offered wage...

... ..
...
........ θ
... .
....
...
... .
.......
... ....
... ..
......
... ....
... .
.......
... ...
... ..... ............ r (θ)
............................................................................................................. w
.
...
... .. .
..........
...
.. .
. ......................... ..
.......................... ........ ..
.. ..... ..
... .
..... ..
... .... ..
... ......
. ..
...
..............................................................................∗..............................................
firm! firm θ home! θ

Julio Dávila Adverse Selection

unfeasible allocation

... ..
...
. ....... θ
... .
....
...
... . .. .....
... ....
... .. . .....
... ....
... .
.........
... ... ..
... ..... .... .......... r (θ)
...
..................................................................−
. ..
....
. . ..............................................................
... .
. .
......
...
.. . w
.. .................................................. ..
.
...... . .. . ..
.. +........ ..
... ..
... ....... ..
... ....... ..
.
........
.........................................................................∗..............................................
firm! firm θ home! θ

Julio Dávila Adverse Selection

non rational expectations

... ..
...
. ....... θ
... .
....
...
... . .. .....
... ....
... .. . .....
... ....
... .
.........
... ... ..
... ..... .... .......... r (θ)
...
..................................................................−
. ..
....
. . ..............................................................
... .
. .
......
...
.. . w
.. .................................................. ..
.
...... . .. . .
...E (θ)
.. +........ ..
... ..
... ....... ..
... ....... ..
.
........
.........................................................................∗..............................................
firm! firm θ home! θ

Julio Dávila Adverse Selection

let w be the offered wage

... ..
... .
........ θ
... ....
...
... .
.......
... ....
... ........
... ....
... ... .....
... ...
......................................................................................................r (θ), w = E (θ)
. .. ..
..
... ...
..
............................................... ..
.. .......................................... ..... ..
...... .. ... ..
... .... ..
... ..
.
... ......... ..
..
.. .....
... .... .
.........................................................................................................................
firm! firm θ∗

Julio Dávila Adverse Selection

feasible allocation

... ......θ
...
... . . . ..... ....
.... ....
...
... . . . ..... ...
...
... ...... ...
..
... ..
... .
.. .... − .....
... ... ...
... .
..... .
................................................................ ..............................................................................r (θ), w = E (θ)
...
... ..
... ...................... ....... .
..
...
..
...
...
..............
............................. ..
..................... ....... ..
.. +...... ..
... ...
. ..
... .... . ..
... ......
. ..
. .
............................................................................................................................ ∗
firm! firm θ

Julio Dávila Adverse Selection

rational expectations

... ....
...
. . . ...... ....θ
... .... .....
...
... . . . ..... ...
...
... ...... ...
...
... ...
... ... ... − ...
...
... ...... ..
... ...
................................................................. ...............................................................................r (θ), w = E (θ)
.
.. .
... .
... ...................... ... .
..
...
...
........
.........
..
..
........................... ..
......................... ....... ..
.. +...... ..
... .
.... ..
... ..... ..
... ....... ..
..
............................................................................................................................ ∗
firm! firm θ

Julio Dávila Adverse Selection

inefficient equilibrium

... ....
...
. . . ...... ....θ
... .... .....
...
... . . . ..... ...
...
... ...... ...
...
... ...
... ... ... − ...
...
... ...... ..
... ...
................................................................. ...............................................................................r (θ), w = E (θ)
.
.. .
... .
... ...................... ... .
..
...
...
........
.........
..
..
........................... ..
......................... ....... ..
.. +...... ..
... .
.... ..
... ..... ..
... ....... ..
..
............................................................................................................................ ∗
firm! firm θ

Julio Dávila Adverse Selection

another inefficient equilibrium

... ..
...
..
. ...... θ
... ....
...
... ........
... ....
... ... .....
... ....
... ........
... ...
... .....
. ................... r (θ), w = E (θ)
...
...... ..............................................
.
..
... .........
. .........................
.......................... ........
.. ...
... .
.. .....
... .....
.. ......
. ..
....∗...........................................................................................................................w = ”E (θ)”
θ home θ

Julio Dávila Adverse Selection

adverse selection

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

Julio Dávila Adverse Selection

adverse selection

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)

Julio Dávila Adverse Selection

adverse selection

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

Julio Dávila Adverse Selection

adverse selection

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff r (θ) ≤ w

Julio Dávila Adverse Selection

adverse selection

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff
Z r −1 (w )
(θ − w )f (θ)dθ = 0
θ

Julio Dávila Adverse Selection

adverse selection

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff
Z r −1 (w )
1
(θ − w ) dθ = 0
θ θ̄ − θ

Julio Dávila Adverse Selection

adverse selection

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff
Z r −1 (w )
1
(θ − w )dθ = 0
θ̄ − θ θ

Julio Dávila Adverse Selection

adverse selection

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff
r −1 (w )
1 1 2 
( θ − w θ) =0
θ̄ − θ 2 θ

Julio Dávila Adverse Selection

adverse selection

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff

1 −1 1
(r (w ))2 − wr −1 (w ) = θ2 − w θ
2 2
if r (θ) = 12 (θ − θ) + θ, then r −1 (w ) = 2(w − θ) + θ

Julio Dávila Adverse Selection

adverse selection

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff

1 −1 1
(r (w ))2 − wr −1 (w ) = θ2 − w θ
2 2
if r (θ) = 12 (θ − θ) + θ , then r −1 (w ) = 2(w − θ) + θ

Julio Dávila Adverse Selection

adverse selection

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff

1 −1 1
(r (w ))2 − wr −1 (w ) = θ2 − w θ
2 2
if r (θ) = 12 (θ − θ) + θ, then r −1 (w ) = 2(w − θ) + θ

Julio Dávila Adverse Selection

adverse selection

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff

1 −1 1
(r (w ))2 − wr −1 (w ) = θ2 − w θ
2 2
if r (θ) = 12 (θ − θ) + θ, then r −1 (w ) = 2w − θ

Julio Dávila Adverse Selection

adverse selection

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff

1 1
(2w − θ)2 − w (2w − θ) = θ2 − w θ
2 2
if r (θ) = 12 (θ − θ) + θ, then r −1 (w ) = 2w − θ

Julio Dávila Adverse Selection

adverse selection

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff

1 1
(4w 2 − 4w θ + θ2 ) − w (2w − θ) = θ2 − w θ
2 2
if r (θ) = 12 (θ − θ) + θ, then r −1 (w ) = 2w − θ

Julio Dávila Adverse Selection

adverse selection

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff

1 1
(4w 2 − 4w θ +θ2 ) − w (2w − θ) = θ2 − w θ
2 2
if r (θ) = 12 (θ − θ) + θ, then r −1 (w ) = 2w − θ

Julio Dávila Adverse Selection

adverse selection

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff

1 1
(4w 2 − 4w θ +θ2 ) − w (2w − θ) = θ2 − w θ
2 2
if r (θ) = 12 (θ − θ) + θ, then r −1 (w ) = 2w − θ

Julio Dávila Adverse Selection

adverse selection

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff

1 1
(4w 2 − 4w θ +θ2 ) − w (2w − θ) = θ2 − w θ!!
2 2
if r (θ) = 21 (θ − θ) + θ, then r −1 (w ) = 2w − θ

Julio Dávila Adverse Selection

adverse selection

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

any w ∈ [θ, θ + 12 (θ̄ − θ)] is a competitive equilibrium

Julio Dávila Adverse Selection

half as productive at home...

... .... θ
...
... ..
......
....
...
... .
.......
... ....
... .
.......
... ....
... .
.......
... ...
... . .....
. ....... r (θ)
...
... .
......
.
....
. ......... w = E (θ)
.... .......
...
... .
....... .............
... .... .......
... ..
...... ..............
... ...... .........
... ................
.
................................................................................................................................
firm

Julio Dávila Adverse Selection

half as productive at home...

... .... θ
...
... ..
......
....
...
... .
.......
... ....
... .
.......
... ....
... .
.......
... ...
... . .....
. ....... r (θ)
...
... .
......
.
....
. ......... w = E (θ)
.... .......
...
... .
....... .............
... .... .......
... ..
...... ..............
... ...... .........
... ................
.
................................................................................................................................
firm

Julio Dávila Adverse Selection

let w be the offered wage

... .... θ
...
... ........
....
...
... ... .....
... ....
... ..
. .....
... ....
... ..
. .....
... ...
... ....
. ..... r (θ)
.. ..
.. .........
................................................................................................ w = E (θ)
.. .... ....... ...
...
.. ..
...... ..
.. ......... ..
.
...
..
....... .............. ..
... .... ....... ..
.
.
... ..... .......... . ..
.
. . ..
..........................................................................................................∗......................
firm θ home!

Julio Dávila Adverse Selection

feasible allocation

... .... θ
...
... .
.......
....
...
... ... . .....
... .... .
... ... ..... ...
... .... ..
... ........ .
... .. ... − ..
... .. .. ........ r (θ)
.. ..... . ......
................................................................................................................................. w = E (θ)
...
..
+ ........
.. ....... ...
...
.. .. . .... ........ ..
.
...
..
....... .............. ..
... .... ....... ..
.
.
... ..... .......... . ..
.
. . ..
..........................................................................................................∗......................
firm θ home!

Julio Dávila Adverse Selection

rational expectations

... .... θ
...
... .
.......
....
...
... ... . .....
... .... .
... ... ..... ...
... .... ..
... ........ .
... .. ... − ..
... .. .. ........ r (θ)
.. ..... . ......
.................................................................................................................................. w = E (θ)
...
..
+ ........
.. ....... ...
...
.. .. . .... ........ ..
.
...
..
....... .............. ..
... .... ....... ..
.
.
... ..... .......... . ..
.
. . ..
..........................................................................................................∗......................
firm θ home!

Julio Dávila Adverse Selection

Akerloff’s market for ”lemons”

Julio Dávila Adverse Selection

Akerloff’s market for ”lemons”

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff

1 −1 1
(r (w ))2 − wr −1 (w ) = θ2 − w θ
2 2

Julio Dávila Adverse Selection

Akerloff’s market for ”lemons”

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff

1 −1 1
(r (w ))2 − wr −1 (w ) = θ2 − w θ
2 2
if r (θ) = 12 (θ − θ) + θ, then r −1 (w ) = 2(w − θ) + θ

Julio Dávila Adverse Selection

Akerloff’s market for ”lemons”

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff

1 −1 1
(r (w ))2 − wr −1 (w ) = θ2 − w θ
2 2
if r (θ) = 23 (θ − θ) + θ, then r −1 (w ) = 32 (w − θ) + θ

Julio Dávila Adverse Selection

Akerloff’s market for ”lemons”

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff

1 −1 1
(r (w ))2 − wr −1 (w ) = θ2 − w θ
2 2
if r (θ) = 23 (θ − θ) + θ, then r −1 (w ) = 32 w − 21 θ

Julio Dávila Adverse Selection

Akerloff’s market for ”lemons”

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff
 2  
1 3 1 3 1 1
w− θ −w w− θ = θ2 − w θ
2 2 2 2 2 2

if r (θ) = 23 (θ − θ) + θ

Julio Dávila Adverse Selection

Akerloff’s market for ”lemons”

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff
    
1 3 1 3 1 1
w − θ −w w − θ = θ2 − w θ
2 2 2 2 2 2

if r (θ) = 23 (θ − θ) + θ

Julio Dávila Adverse Selection

Akerloff’s market for ”lemons”

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff
  
3 1 3 1 1
w − θ−w w − θ = θ2 − w θ
4 4 2 2 2

if r (θ) = 23 (θ − θ) + θ

Julio Dávila Adverse Selection

Akerloff’s market for ”lemons”

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff
  
1 1 3 1 1
− w+ θ w − θ = θ2 − w θ
4 4 2 2 2

if r (θ) = 23 (θ − θ) + θ

Julio Dávila Adverse Selection

Akerloff’s market for ”lemons”

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff
 
3 1
[w + θ] w − θ = 4w θ − 2θ2
2 2

if r (θ) = 23 (θ − θ) + θ

Julio Dávila Adverse Selection

Akerloff’s market for ”lemons”

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff

3 2 1 3 1
w − θw + θw − θ2 = 4w θ − 2θ2
2 2 2 2
if r (θ) = 23 (θ − θ) + θ

Julio Dávila Adverse Selection

Akerloff’s market for ”lemons”

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff

3 2 1 3 3
w − θw + θw + θ2 = 4w θ −2θ2
2 2 2 2
if r (θ) = 23 (θ − θ) + θ

Julio Dávila Adverse Selection

Akerloff’s market for ”lemons”

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff

3 2 3 3
w − 3θw + θw + θ2 = 0w θ − 2θ2
2 2 2
if r (θ) = 23 (θ − θ) + θ

Julio Dávila Adverse Selection

Akerloff’s market for ”lemons”

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff

3
(w − θ)2 = 0
2
if r (θ) = 23 (θ − θ) + θ

Julio Dávila Adverse Selection

Akerloff’s market for ”lemons”

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

accept employment iff θ ≤ r −1 (w )

firm/planner breaks even iff

3
(w = θ)2 = 0
2
if r (θ) = 23 (θ − θ) + θ

Julio Dávila Adverse Selection

Akerloff’s market for ”lemons”

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

only w = θ is a competitive equilibrium

Julio Dávila Adverse Selection

Akerloff’s market for ”lemons”

1 f ∈ [0, 1][θ,θ̄] , density of types/productivity in firm

[θ,θ̄]
2 r ∈ R+ , productivity at home (increasing in types)
3 w wage

only w = θ is a competitive equilibrium

in which no trade takes place in the market

Julio Dávila Adverse Selection

66% as productive at home...

... .... θ
...
... ..
......
....
...
... ..
. .....
... ....
... ..
. .....
... .... ..... r (θ)
... .
....... ..
.. ......
.
... ... ....
...
........ .
.. ........
... . .
.... ......
...
... .
....... ........... w = E (θ)
... ...... ........
... .... .....
... ..
.................
... .............
... ..............
.
.............................................................................................................................
firm

Julio Dávila Adverse Selection

66% as productive at home...

... .... θ
...
... ..
......
....
...
... ..
. .....
... ....
... ..
. .....
... .... ..... r (θ)
... .
....... ..
.. ......
.
... ... ....
...
........ .
.. ........
... . .
.... ......
...
... .
....... ........... w = E (θ)
... ...... ........
... .... .....
... ..
.................
... .............
... ..............
.
.............................................................................................................................
firm

Julio Dávila Adverse Selection

let w be the offered wage

... .... θ
...
... ..
......
....
...
... .
.. .....
... ....
... .
.......
... .... ......r (θ)
... ..
...... ..
. . ......
.
.................................................................................... w = E (θ)
... .. ...
... .
....... ........... ...
... .... ..... ..
... .
....... ........... ..
... .
..... ........ ..
... .
..... ........ ..
... ................ ..
... ................ ..
.
..........
.................................................................................................∗......................
firm θ home!

Julio Dávila Adverse Selection

let w be the offered wage

... .... θ
...
... ..
......
....
...
... .
. . .....
... ....
... .
.......
... .... ......r (θ)
... ..
...... ..
. . ......
.
.................................................................................... w = E (θ)
... .. ...
... .
....... ........... ....
... .... ..... ....
... .
....... ........... .. E (θ)
... .
..... ........ ..
... .
..... ........ ..
... ................ ..
... ................ ..
.
..........
.................................................................................................∗......................
firm θ home!

Julio Dávila Adverse Selection

let w be the offered wage

... .... θ
...
... ........
....
...
... .
.. .....
... ....
... .
....... .
... .... ....... r (θ)
... ..
...... .
...
. .......
....................................................................................
... ... ..... .
.............................. ..............................................................
... ... ... ...E (θ) w = E (θ)
... ..
. ..... ........... ... ..
. .
...
.
....... ........... ..
. ..
... .
. .. .......
. .. ..
... .... ...... . .. ..
..
... .............. .. ..
.
. . .
...............................................................................∗...............................................
firm θ home!

Julio Dávila Adverse Selection

let w be the offered wage

... .... θ
...
... ........
....
...
... .
.. .....
... ....
... .
....... .
... .... ....... r (θ)
... ..
...... .
...
. .......
....................................................................................
... ... ..... .
.............................. .............................................................
... ... ... w = E (θ)
... ..
. ..... ........... ..... ..
..
... ... ..
. .
... ..... .. E (θ) ..
...
..
. ................
. .. ..
... .... ...... .. ..
..
... .............. .. ..
.
. . .
...............................................................................∗...............................................
firm θ home!

Julio Dávila Adverse Selection

let w be the offered wage

... .... θ
...
... ........
....
...
... .
.. .....
... ....
... .
....... .
... .... ....... r (θ)
... ..
...... .
...
. .......
...................................................................................
... ... ....... .
............................................................................................
... .... ...... .
.............................................................................................. w = E (θ)
... .
... .... . . .. E (θ) ..
...
..
. ................. ...
. .. ..
... .... ...... .. .. ..
..
... .............. .. .. ..
.
. . .
..............................................................∗.................................................................
firm θ home!

Julio Dávila Adverse Selection

let w be the offered wage

... .... θ
...
... ........
....
...
... .
.. .....
... ....
... .
....... .
... .... ....... r (θ)
... ..
...... .
...
. .......
...................................................................................
... ... ....... .
............................................................................................
... .... ...... .
............................................................................................. w = E (θ)
... .
... .... . . .. ..
...
..
. ................. .....
. .. ..
... .... ......
.. .. .. E (θ).. ..
... ............ .. .. ..
.
. . .
..............................................................∗.................................................................
firm θ home!

Julio Dávila Adverse Selection

let w be the offered wage

... ..
... ........ θ
... ...
...
. ........
... ....
...
... .
.......
... .... ......
.. r (θ)
... ........ .....
... .... .....
... .. . ..... ............... ......
... ... ..... .. ......
... .
....... ...........................................
.
... .... ...... .........
...
... .
....... .......................................
. ..
... ..... ...... .......
... ...............................
... .....................
....
............................................................................................................................... w = E (θ)
E (θ) home!

Julio Dávila Adverse Selection

what if firms can compete in wages?

Assume that
1 the distribution function F over [θ, θ̄]

Julio Dávila Adverse Selection

what if firms can compete in wages?

Assume that
1 the distribution function F over [θ, θ̄]
2 the reservation value r ∈ R[θ,θ̄] is increasing

Julio Dávila Adverse Selection

what if firms can compete in wages?

Assume that
1 the distribution function F over [θ, θ̄]
2 the reservation value r ∈ R[θ,θ̄] is increasing
3 first, two firms 1 and 2 announce simultaneously wage offers
w1 and w2

Julio Dávila Adverse Selection

what if firms can compete in wages?

Assume that
1 the distribution function F over [θ, θ̄]
2 the reservation value r ∈ R[θ,θ̄] is increasing
3 first, two firms 1 and 2 announce simultaneously wage offers
w1 and w2
4 then, the workers such that r (θ) ≤ w = max{w1 , w2 } accept
w (any wi with equal probabilities if equal)

Julio Dávila Adverse Selection

what if firms can compete in wages?

Assume that
1 the distribution function F over [θ, θ̄]
2 the reservation value r ∈ R[θ,θ̄] is increasing
3 first, two firms 1 and 2 announce simultaneously wage offers
w1 and w2
4 then, the workers such that r (θ) ≤ w = max{w1 , w2 } accept
w (any wi with equal probabilities if equal)
5 F and r are common knowledge

Julio Dávila Adverse Selection

what if firms can compete in wages?

Assume that
1 the distribution function F over [θ, θ̄]
2 the reservation value r ∈ R[θ,θ̄] is increasing
3 first, two firms 1 and 2 announce simultaneously wage offers
w1 and w2
4 then, the workers such that r (θ) ≤ w = max{w1 , w2 } accept
w (any wi with equal probabilities if equal)
5 F and r are common knowledge
6 if w ∗ is the biggest w such that E (θ | r (θ) ≤ w ) = w , then

E (θ | r (θ) ≤ w ∗ − ) > w ∗ − 

for  > 0 small enough

Julio Dávila Adverse Selection

what if firms can compete in wages?

let (w1 , w2 ) be a Nash equilibrium profile of strategies such

that w = max{w1 , w2 } > r (θ)

Julio Dávila Adverse Selection

what if firms can compete in wages?

let (w1 , w2 ) be a Nash equilibrium profile of strategies such

that w = max{w1 , w2 } > r (θ)
1 aggregate profits are necessarily nonnegative, i.e.

π = E (θ | r (θ) ≤ w ) − w r −1 (w ) − θ ≥ 0
 

Julio Dávila Adverse Selection

what if firms can compete in wages?

let (w1 , w2 ) be a Nash equilibrium profile of strategies such

that w = max{w1 , w2 } > r (θ)
1 aggregate profits are necessarily nonnegative, i.e.

π = E (θ | r (θ) ≤ w ) − w r −1 (w ) − θ ≥ 0
 

2 one of the firms gets at most 21 π

Julio Dávila Adverse Selection

what if firms can compete in wages?

let (w1 , w2 ) be a Nash equilibrium profile of strategies such

that w = max{w1 , w2 } > r (θ)
1 aggregate profits are necessarily nonnegative, i.e.

π = E (θ | r (θ) ≤ w ) − w r −1 (w ) − θ ≥ 0
 

2 one of the firms gets at most 21 π

3 if that firm deviates to offer w + , its payoffs increase in at
least π − 21 π, for  > 0 small enough

Julio Dávila Adverse Selection

what if firms can compete in wages?

let (w1 , w2 ) be a Nash equilibrium profile of strategies such

that w = max{w1 , w2 } > r (θ)
1 aggregate profits are necessarily nonnegative, i.e.

π = E (θ | r (θ) ≤ w ) − w r −1 (w ) − θ ≥ 0
 

2 one of the firms gets at most 21 π

3 if that firm deviates to offer w + , its payoffs increase in at
least π − 21 π, for  > 0 small enough
4 necessarily then π = 0

Julio Dávila Adverse Selection

what if firms can compete in wages?

let (w1 , w2 ) be a Nash equilibrium profile of strategies such

that w = max{w1 , w2 } > r (θ)
1 aggregate profits are necessarily zero, i.e.

π = E (θ | r (θ) ≤ w ) − w r −1 (w ) − θ = 0
 

Julio Dávila Adverse Selection

what if firms can compete in wages?

let (w1 , w2 ) be a Nash equilibrium profile of strategies such

that w = max{w1 , w2 } > r (θ)
1 aggregate profits are necessarily zero, i.e.

π = E (θ | r (θ) ≤ w ) − w r −1 (w ) − θ = 0
 

2 then E (θ | r (θ) ≤ w ) = w

Julio Dávila Adverse Selection

what if firms can compete in wages?

let (w1 , w2 ) be a Nash equilibrium profile of strategies such

that w = max{w1 , w2 } > r (θ)
1 aggregate profits are necessarily zero, i.e.

π = E (θ | r (θ) ≤ w ) − w r −1 (w ) − θ = 0
 

2 then E (θ | r (θ) ≤ w ) = w
3 assume w < w ∗

Julio Dávila Adverse Selection

what if firms can compete in wages?

let (w1 , w2 ) be a Nash equilibrium profile of strategies such

that w = max{w1 , w2 } > r (θ)
1 aggregate profits are necessarily zero, i.e.

π = E (θ | r (θ) ≤ w ) − w r −1 (w ) − θ = 0
 

2 then E (θ | r (θ) ≤ w ) = w
3 assume w < w ∗
since E (θ | r (θ) ≤ w ∗ − ) > w ∗ −  for  > 0 small enough, if
a firm deviates to offer w ∗ −  then its payoff increase to

E (θ | r (θ) ≤ w ∗ − ) − (w ∗ − ) r −1 (w ∗ − ) − θ > 0
 

Julio Dávila Adverse Selection

what if firms can compete in wages?

let (w1 , w2 ) be a Nash equilibrium profile of strategies such

that w = max{w1 , w2 } > r (θ)
1 aggregate profits are necessarily zero, i.e.

π = E (θ | r (θ) ≤ w ) − w r −1 (w ) − θ = 0
 

2 then E (θ | r (θ) ≤ w ) = w
3 then w = w∗
downwards deviations are not profitable
upward deviations are not profitable either:
for all w 0 > w , either E (θ | r (θ) ≤ w 0 ) < w 0 or
E (θ | r (θ) ≤ w 0 ) > w 0

Julio Dávila Adverse Selection

what if firms can compete in wages?

let (w1 , w2 ) be a Nash equilibrium profile of strategies such

that w = max{w1 , w2 } > r (θ)
1 aggregate profits are necessarily zero, i.e.

π = E (θ | r (θ) ≤ w ) − w r −1 (w ) − θ = 0
 

2 then E (θ | r (θ) ≤ w ) = w
3 then w = w ∗ = wi , for all i = 1, 2

Julio Dávila Adverse Selection

what if firms can compete in wages?

let (w1 , w2 ) be a Nash equilibrium profile of strategies such

that w = max{w1 , w2 } > r (θ)
1 aggregate profits are necessarily zero, i.e.

π = E (θ | r (θ) ≤ w ) − w r −1 (w ) − θ = 0
 

2 then E (θ | r (θ) ≤ w ) = w
3 then w = w ∗ = wi , for all i = 1, 2
4 downwards deviations are not profitable

Julio Dávila Adverse Selection

what if firms can compete in wages?

let (w1 , w2 ) be a Nash equilibrium profile of strategies such

that w = max{w1 , w2 } > r (θ)
1 aggregate profits are necessarily zero, i.e.

π = E (θ | r (θ) ≤ w ) − w r −1 (w ) − θ = 0
 

2 then E (θ | r (θ) ≤ w ) = w
3 then w = w ∗ = wi , for all i = 1, 2
4 downwards deviations are not profitable
5 upward deviations are not profitable either:

Julio Dávila Adverse Selection

what if firms can compete in wages?

let (w1 , w2 ) be a Nash equilibrium profile of strategies such

that w = max{w1 , w2 } > r (θ)
1 aggregate profits are necessarily zero, i.e.

π = E (θ | r (θ) ≤ w ) − w r −1 (w ) − θ = 0
 

2 then E (θ | r (θ) ≤ w ) = w
3 then w = w ∗ = wi , for all i = 1, 2
4 downwards deviations are not profitable
5 upward deviations are not profitable either:
for all w 0 > w ,
either E (θ | r (θ) ≤ w 0 ) < w 0
or E (θ | r (θ) ≤ w 0 ) > w 0

Julio Dávila Adverse Selection

what if firms can compete in wages?

let (w1 , w2 ) be a Nash equilibrium profile of strategies such

that w = max{w1 , w2 } > r (θ)
1 aggregate profits are necessarily zero, i.e.

π = E (θ | r (θ) ≤ w ) − w r −1 (w ) − θ = 0
 

2 then E (θ | r (θ) ≤ w ) = w
3 then w = w ∗ = wi , for all i = 1, 2
4 downwards deviations are not profitable
5 upward deviations are not profitable either:
for all w 0 > w ,
either E (θ | r (θ) ≤ w 0 ) < w 0
or E (θ | r (θ) ≤ w ) > +∞!! as w 0 → +∞

Julio Dávila Adverse Selection

what if firms can compete in wages?

let (w1 , w2 ) be a Nash equilibrium profile of strategies such

that w = max{w1 , w2 } > r (θ)
1 aggregate profits are necessarily zero, i.e.

π = E (θ | r (θ) ≤ w ) − w r −1 (w ) − θ = 0
 

2 then E (θ | r (θ) ≤ w ) = w
3 then w = w ∗ = wi , for all i = 1, 2
4 downwards deviations are not profitable
5 upward deviations are not profitable either:
for all w 0 > w ,
E (θ | r (θ) ≤ w 0 ) < w 0
or E (θ | r (θ) ≤ w ) > +∞!! as w → +∞

Julio Dávila Adverse Selection

what if firms can compete in wages?

let (w1 , w2 ) be a Nash equilibrium profile of strategies such

that w = max{w1 , w2 } > r (θ)
1 aggregate profits are necessarily zero, i.e.

π = E (θ | r (θ) ≤ w ) − w r −1 (w ) − θ = 0
 

2 then E (θ | r (θ) ≤ w ) = w
3 then w = w ∗ = wi , for all i = 1, 2
4 downwards deviations are not profitable
5 upward deviations are not profitable either:
for all w 0 > w ,
E (θ | r (θ) ≤ w 0 ) − w 0 r −1 (w 0 ) − θ < 0


or E (θ | r (θ) ≤ w ) > +∞!! as w → +∞

Julio Dávila Adverse Selection