Signalling

3 key takeaways

• Signalling involves actions taken to reveal information to others, especially in situations of asymmetric information.
• Effective signals are costly to transmit and vary in cost across individuals, making it worthwhile for some to signal but not for others.
• Common examples include educational qualifications and advertising, where the actions signal underlying qualities like ability or product quality.

What is signalling?

Signalling is a concept in economics and game theory where one party (the informed party) uses certain actions or attributes to convey information to another party (the uninformed party). This occurs in situations of asymmetric information, where one party has more or better information than the other.

How signalling works

For signalling to be effective, the signal must be credible and costly to fake. This means that the cost of sending the signal must be sufficiently high to deter those who do not possess the underlying quality being signalled from sending the signal.

Example of signalling in education

One classic example of signalling is in the job market, where students seek educational qualifications to signal their abilities to prospective employers. Even if the specific subject studied is not directly relevant to the job, the attainment of a degree serves as a signal of the candidate’s diligence, intelligence, and capability. Employers interpret these signals to make hiring decisions.

• Cost of the signal: Obtaining a degree requires time, effort, and money, which makes it costly.
• Differential cost: The cost of obtaining a degree is lower for high-ability individuals (because they find it easier to study and pass exams) than for low-ability individuals.
• Outcome: As a result, it is rational for high-ability individuals to obtain the degree, while low-ability individuals may find it not worthwhile, making the degree a credible signal of ability.

Signalling in markets

Signalling is also prevalent in markets, particularly in advertising. Companies use advertising to signal the quality of their products to consumers. For advertising to be a credible signal, it must be costly, and the cost must be justified by the expected revenue from higher sales of high-quality products.

• Example: A company spends heavily on advertising its high-quality product. The high cost of advertising is justified by the high sales and customer satisfaction that result from the superior quality. Conversely, a company with a low-quality product would find it unprofitable to spend heavily on advertising, as the high cost would not be offset by repeat purchases or customer satisfaction.

Challenges and limitations of signalling

While signalling can be an effective way to convey information, it also has its challenges:

• Costly for all: Not all signals are perfectly effective. Some signals may be too costly for even high-quality individuals to afford, or they may not sufficiently differentiate between high and low-quality individuals.
• Misinterpretation: There is a risk that signals may be misinterpreted or that the cost of the signal does not perfectly correlate with the underlying quality.
• Strategic behavior: Both senders and receivers of signals may engage in strategic behavior that complicates the signalling process.

Historical context and legacy

The concept of signalling was significantly developed by Michael Spence, who introduced the idea in the context of job market signaling. His work earned him the Nobel Prize in Economic Sciences in 2001, shared with George Akerlof and Joseph Stiglitz for their analyses of markets with asymmetric information.

Understanding signalling provides valuable insights into how individuals and firms convey information in situations where direct observation is not possible.

For further exploration, one might study the application of signalling in various fields, such as finance (e.g., signaling through dividend policies), insurance (e.g., health signals), and beyond.