Screening and Signaling

Screening and Signaling Edition 7: Chapter 12, pages 450-454 Edition 6: Chapter 12, pages 450-456

Screening and Signaling • Definitions: Screening- An attempt by an uninformed party to sort individuals according to their characteristics. Signaling- An attempt by an informed party to send an observable indicator of his or her hidden characteristics to an uniformed party.

Examples of Screening • Screening to enable price discrimination (coupons, rebates, outlet malls,…) • Screening to sort different types of workers. • Choice of deductibles associated with different types of insurance. • Obtaining a physical to obtain a favorable life insurance policy.

Examples of Signaling • Obtaining an advanced degree such as an MBA or PhD. • Seller offering a warranty. • Labor contract negotiations/ Negotiating a compensation package.

Example 1: Signaling with a Warranty • Suppose there are sellers of lemons and sellers of peaches and buyers cannot tell a lemon from a peach (like the adverse selection example we did). Suppose a seller can obtain a price of $2,000 if he has a lemon and the buyer knows it’s a lemon and a price of $3,000 if he has a peach and the buyer knows it’s a peach. Finally, assume all sellers can credibly offer a warranty.

Example 1: Signaling with a Warranty • Let the probability of a lemon breaking down be .70 and the probability of a peach breaking down be .10. Suppose the warranty states that if the car breaks down, the seller will pay the buyer $1,500 to repair the car.

Example 1: Signaling with a Warranty • Will the seller with a lemon offer the warranty? Marginal Benefit (MB) from offering the warranty is $1,000. Marginal Cost (MC) from offering the warranty is .7*1500=$1,050. • Will the seller with a peach offer the warranty? Marginal Benefit (MB) from offering the warranty is $1,000. Marginal Cost (MC) from offering the warranty is .1*1500=$150. MB<MC for seller with lemon and MB>MC for seller with peach. Therefore, seller with peach can credibly signal to buyer that the car is a peach by offering the above warranty.

Example 2: Signaling in National Football League Contract Negotiations • Time Table for “Rookies” Draft Day - Late April Start of Training Camp – Early July Start of Regular Season – Late August

Example 2: Signaling in National Football League Contract Negotiations Draft • Prior to the draft, teams obtain information (size, strength, speed, character and intelligence) about players through interviews, pre-draft workouts and game films. • Each NFL team is given one draft pick in each round to select a player or trade. The order in which teams draft in each round depends on the teams’ performance the previous season. • The team that drafts the player has the “rights” to that player for at least a year.

Example 2: Signaling in National Football League Contract Negotiations Training Camp • Teams hold training camps so the players can learn the team’s offensive and defensive systems and achieve proper conditioning. Contract Negotiations • The majority of drafted players hire agents to negotiate their contracts. • Negotiations might occur in a series of meetings or a series of phone calls. • Drafted players sign what is termed a Standard Form Contract (SFC). These contracts are almost always non-guaranteed.

Example 2: Signaling in National Football League Contract Negotiations Guaranteed • Representative Contract Non-Guaranteed

Summary Statistics of Contract Data

Example 2: Signaling in National Football League Contract Negotiations What are the different manners by which a player can signal his private information? • Propose a contract with a small fraction of the compensation in guaranteed money (i.e., small signing bonus). • Propose a contract with a lot of incentive clauses in the contract. • Negotiate a short contract. • Hold out and miss part of training camp.

Example 2: Signaling in National Football League Contract Negotiations On the sidelines: An annual Economic Analysis of the National Football League prepared for members of the NFL Players Association • “… never recovered from his holdout and remains a reserve.... Maybe his agents should have recognized that he was a player who needed to be in camp early....” • “(The holdout) made my first year kind of rough. When I got into camp it took a while to get adjusted...”.

Illustration of why player can signal by holding out and missing part of training camp Consider a player who can obtain a one-year, non-guaranteed contract worth $200,000 if he signs before the start of training camp or can obtain a one-year, non-guaranteed contract worth $250,000 if he holds out and signs 5 days after the start of training camp. If the player does not make the team, he can make $50,000 selling insurance.

Illustration of why player can signal by holding out and missing part of training camp Suppose the player can either have negative private information or positive private information. For example, the player could know that the injury to his right knee in college is still bothering him (negative private information) or that he did not perform as well as he should have in college because his coach did not like him (positive private information).

Illustration of why player can signal by holding out and missing part of training camp Player with negative private information If he signs before training camp, his probability of making the team is .6. If he holds out and signs after the start of training camp, his probability of making the team is .3. Expected payoff from signing before training camp is .6($200,000)+.4($50,000)=$140,000 Expected payoff from signing after training camp is .3($250,000)+.7($50,000)=$110,000 Player with negative information agrees to $200k contract prior to the start of training camp.

Illustration of why player can signal by holding out and missing part of training camp Player with positive private information If he signs before training camp, his probability of making the team is .75. If he holds out and signs after the start of training camp, his probability of making the team is .6. Expected payoff from signing before training camp is .75($200,000)+.25($50,000)=$162,500 Expected payoff from signing after training camp is .6($250,000)+.4($50,000)=$170,000 Player with positive information agrees to $250k contract after the start of training camp.

Team’s Decision • Team is willing to pay a player who signs after the start of training camp more because the team realizes that the player is signaling his positive private information.

Example 2: Signaling in National Football League Contract Negotiations On the sidelines: An annual Economic Analysis of the National Football League prepared for members of the NFL Players Association “When a contract is signed has a major impact on what gets signed. For draftees especially, early deals as a rule produce numbers not only below the final averages in a round, but in many cases also under averages from the previous season.”

What the data should reveal if players with positive private information sign after the start of training camp. • Players who sign after the start of training camp should receive more lucrative contracts and perform better (perhaps not in their first year) than players who sign before the start of training camp(conditional on when they were selected in the draft, their position, the team that drafted them, etc…).

Proportion that “Make Team” and Mean Number of Starts

Conclusions • Conditional on Round Drafted, Players who sign after the start of training camp are more likely to “make the team” than players who sign before training camp. • Conditional on Round Drafted, Players who sign after the start of training camp start less games the first year after being drafted and more game the third year after being drafted than players who sign before training camp.

What does this have to do with you interviewing for a job and negotiating a compensation package?

Screening and Signaling