2. Education as a Signal
• Two Groups- Group 1 (Average Product= 1)
• Group 2 (Average Product = 2)
• Each output sells at Rs 1 lakh
• If you knew each firm’s quality what would be
the salary of Group 1 . Group 2?
• What if you did not know the quality of the
two?
3. Education as a Signal
• Y: years of education
• Higher education , higher costs
• Each group has different costs of education
• Group 1, C1 (Y) = Rs 4,00,000 Y
• Group 2, C2 (Y) = Rs 2,00,000 Y
4. Education as a Signal
• Assume the following decision rule is followed
by the firm
“ Anyone with education higher than y* or more
is a Group 2 person and will be given an
income of Rs 2lkh. Anyone with education less
than y* will be given an income of Rs 1lkh.”
5. Value of
Education as a Signal
education
10,00,000
B(y)
0 y*
6. Education as a Signal
• No education level between 0 and y* will be
chosen
• No education level more than y* will be
chosen
7. Choice of Education
• Group 1
Benefit: Rs 10,00,000
Cost: 4,00,000y*
Choose that y* such that Group 1 does not
educate him self
• y*> 2.5
8. Choice of Education
• Group 2
Benefit: Rs 10,00,000
Cost: 2,00,000y*
Choose that y* such that Group 1 does not educate
him self
• y*<5
• Any y* such that 2.5 <y*< 5 would do
9. Value of
Education as a Signal
education
C1 (y) = 40,000y
1,00,000
B(y)
0 y*
Group 1
Optimal Choice
10. Value of
Education as a Signal
education
C2 (y) = 20,000y
10,00,000
B(y)
0 4
Group 2
Optimal Choice
11. Education as a Signal
• Low productivity people do not get education
• High productivity people get education
• On observing education level of 4 years the
employers rightly believe the person to be of
High productivity
• Even if education does nothing to increase
productivity, some people may want to
differentiate themselves by education.
12. Warranties and Service Plans
• What is the use of Warranties?
• Can Warranties act as signal?
• Signal to what?
13. Warranties
• Problems with the car led consumers to loose
faith in Audi in late 1970s.
• In response Audi introduced “ Audi Card” or “
bumper to bumper” warranty scheme
• Audi sales increased
• Besides improving the benefit of having an
Audi, what else could have been the effect of
this warranty?
14. Audi’s Warranty
• Warranty a signal that Audi is reliable.
• If Audi was not reliable or of high quality, the
probability of repair would be high, leading to
high costs for Audi (because of the warranty)
• Any other car maker with probability of defect
higher than that of Audi would not have
offered this warranty.
• Warranties of gadgets, battery life. Duration
15. Other Examples
• Appearance a signal of wealth
• Advertising as a signal:
- Carorder.com: 50,000 , $3 metro cards for NYC
subway and paid tolls for 100 cars at all area
bridges
- “ Your commute brought to you by
Carorder.com”
17. Auction
• Mechanism to allocate resources
• Competing against other bidders
• How much they value the product?
18. What is an Auction?
• Definition:
– A market institution with rules governing resource
allocation on the basis of bids from participants
• Over 30% of US GDP moves through auctions:
IPOs Wine
Emissions permits Art :Sotheby’s,
Radio Spectrum Chiristie’s
Import quotas Flowers
Advertisement slots: Fish
Google, Yahoo! Houses: Australia
Procurement Treasury bills
Books: eBay, Amazon
19. Procurement Auctions
• Government takes bids for building a road
• Lowest bid wins the auction
• One Buyer, many sellers
• Issues of quality, reputation , efficiency
20. Strategy in Auctions
• How much to bid?
• When to bid?
• Whether to bid at all ?
• How to avoid winning but not regretting?
21. Can of Coins on Auction
• Write the number of coins you think are in
the can
• Write the bid that you would like to make.
• Make a personal note of these and hand over
the chit
22. Auction of Coins
Rule for Group I:
• Highest Bid wins the pot
• Pays the second highest bid
Rule for Group II:
• Highest Bid wins the pot
• Pays the your bid
23. Valuation
• Highest price at which you are indifferent
between winning and losing the object.
• Can include
I. Excitement from winning the object
II. Premium that you put on the object not
landing in your rivals hands.
III. Expected resale value
24. Private V/S Common Valuation
• Common Value Auction
– True value of the good for sale is same for all
– Bidders differ in their estimates of the true value
– e.g., FCC spectrum, drilling,
• Private Value Auction
– Each bidder knows his or her value for the object
– Independent Valuation
– Bidders differ in their values for the object
– e.g., Houses, consumption items
27. Common and Private
Value Auctions
• Each good is a composite of both Common
and Private Value goods.
• Oil Fields: Different costs of drilling the oil
field
• Houses: Resale value
28. Auction of Coins
• Winner: How did you bid for this can?
• How do you feel you have done?
• How did others bid for the can?
29. Bidding in Common Value
• Bid your estimate?
• Bid less than your estimate?
• What if everyone bid their estimate?
30. Auction as a Game
• Payoff in an Auction
• Estimate yi v
• If v is the true value of the object and ε is the
error
• ε is standard normally distributed
• yi has an unbiased normal distribution
31. Winner of Auction
• If everyone bids their estimate
• Winner is the one who has the highest
estimate
• And the one with the highest error
32. Winner’s Curse
• If the average bid in an auction is the actual
value of the object (Law of Large Numbers)
• If everyone bids according to their estimate
• Winner of the highest estimate would be the
one with highest error.
33. Examples
• After WW II, US govt auctioned out rights to
drill in Gulf of Mexico.
• Those who won where constantly loosing
money
• IPL (??)
35. Sealed-Bid
First Price Auctions
• All buyers submit bids
• Buyer submitting the highest bid wins
and pays the price he or she bid
WINNER!
Pays $700
$700 $500
$400 $300
35
36. Auction 2: Dutch (Tulip) Auction
Descending Bid
• “Price Clock” ticks down the price
• First bidder to “buzz in” and stop the clock
is the winner
• Pays price on clock
36
37. Examples of Dutch Auctions
• Amsterdam’s flower market
• US T-bills
• Google IPO
38. Auction 3: Sealed-Bid
Second Price Auctions
• All buyers submit bids
• Buyer submitting the highest bid wins
and pays the second highest bid
WINNER!
Pays $500
$700 $500
$400 $300
39. Auction 3: Vickery Auction
• Attributed to William Vickery, Nobel Laureate,
1961
• Also called, Second price sealed bid auction
• Bids placed in a sealed bid
• Highest bidder wins
• Pays second highest bid
41. Auction 4: Japanese Auction
• Let us change the game now.
• All teams will drop/fold their hands to indicate
no participation in the auction
• Price will rise.
• Auction will end at the price when only one
team remains in auction
• Once you drop out you can not re enters
42. Comparing Vickery and Japanese
Auction
• What is a strategy in this case?
• The bid at which you will lower your hand.
• Who wins? The one who has the highest
intended bid.
• When does it stop? When the 2nd highest
bidder stops.
43. Comparing Vickery and Japanese
Auction
• Are the winners same in Vickery and Japanese
Auction?
• Is the price that the winner pays same in
both?
44. English Auction
• Variation of Japanese Auction
• Price is raised
• Interested parties can raise the price
• Auction ends when no one raises the price
• Houses and Antique, Cattle
45. Difference between English and
Japanese Auction
• Knowledge of who is in the auction
• Knowledge of when a player drops out
Unknown in English Auction
Known in Japanese Auction
46. Comments
• Optimal Bidding strategy
• Which type of auction should be chosen? First
or Second Price Auction
• Should the products be sold sequentially or
simultaneously
Editor's Notes
Australia auction for houses. A house you like is on auction now. Should you bid now or wait for that dream house which may be on auction later?
Divide the class into even number of teams.Ask each team to write the maximum that they are willing to pay for this can of coinsAsk them also to write their actual bids they are willing to pay for the can of coins.Set the rules of the game, The first half of the teams