Signalling (economics)
Signalling (economics)
- Signalling (or signaling**; see spelling differences) is a theory of decision-making and communication under imperfect or incomplete information. It describes situations in which a *signaler* uses observable actions, attributes, or communications (*signals*) to convey credible information about otherwise unobservable qualities to a *receiver*. Signals are most credible when they are *differentially costly* (i.e., harder or more expensive for low-quality signalers to produce or imitate than for high-quality signalers).
Signaling theory is about decision-making and communication under incomplete information. It describes situations in which signalers send observable actions, attributes, or communications that carry credible information about unobservable qualities that matter for a receiver’s choice.
Signaling theory was more fully developed by Michael Spence, specifically in the context of observed knowledge gaps between organisations and prospective employees. Later reviews emphasise additional actors and complexities in signaling systems (including broader stakeholder audiences) and propose directions for future theory development. The concept of signaling is also applicable in competitive altruistic interaction, where the capacity of the receiving party is limited.
Introductory questions Signalling started with the idea of asymmetric information (a deviation from perfect-information), which relates to the fact that, in some economic transactions, inequalities exist in the normal market for the exchange of goods and services. In his seminal 1973 article, Michael Spence proposed that two parties could get around the problem of asymmetric information by having one party send a signal that would reveal some piece of relevant information to the other party. since “sheepskin” informally denotes a diploma. It is important to note that this is not the same as the returns from an additional year of education. The "sheepskin" effect is actually the wage increase above what would normally be attributed to the extra year of education. This can be observed empirically in the wage differences between 'drop-outs' vs. 'completers' with an equal number of years of education. It is also important that one does not equate the fact that higher wages are paid to more educated individuals entirely to signalling or the 'sheepskin' effects. In reality, education serves many different purposes for individuals and society as a whole. Only when all of these aspects, as well as all the many factors affecting wages, are controlled for, does the effect of the "sheepskin" approach its true value. Empirical studies of signalling indicate it as a statistically significant determinant of wages, however, it is one of a host of other attributes—age, sex, and geography are examples of other important factors.
The model To illustrate his argument, Spence imagines, for simplicity, two productively distinct groups in a population facing one employer. The signal under consideration is education, measured by an index y and is subject to individual choice. Education costs are both monetary and psychic. The data can be summarized as:
Suppose that the employer believes that there is a level of education y* below which productivity is 1 and above which productivity is 2. Their offered wage schedule W(y) will be:
: <math>W(y) = \begin{cases} 1, & y < y \\ 2, & y > y \end{cases}</math>
Working with these hypotheses Spence shows that:
There is no rational reason for someone choosing a different level of education from 0 or y*. # Group I sets y=0 if 1>2-y*, that is if the return for not investing in education is higher than investing in education. # Group II sets y=y if 2-y/2>1, that is the return for investing in education is higher than not investing in education. # Therefore, putting the previous two inequalities together, if 1<y*<2, then the employer's initial beliefs are confirmed. # There are infinite equilibrium values of y belonging to the interval [1,2], but they are not equivalent from the welfare point of view. The higher y the worse off is Group II, while Group I is unaffected. # If no signaling takes place each person is paid their unconditional expected marginal product <math>2-q_{1}</math>. Therefore, Group, I is worse off when signaling is present.
In conclusion, even if education has no real contribution to the marginal product of the worker, the combination of the beliefs of the employer and the presence of signalling transforms the education level y* in a prerequisite for the higher paying job. It may appear to an external observer that education has raised the marginal product of labor, without this necessarily being true.
Another model For a signal to be effective, certain conditions must be true. In equilibrium, the cost of obtaining the credential must be lower for high productivity workers and act as a signal to the employer such that they will pay a higher wage. Where multiple audiences observe the same signal, actions intended for one receiver can impose additional “reaction costs” if other observers interpret the signal negatively, which can alter whether the net payoff supports a separating equilibrium.
IPOs Signaling typically occurs in an IPO, where a company issues out shares to the public market to raise equity capital. This arises due to information asymmetry between potential investors and the company raising capital. Given firms are private before an IPO, prospective investors have limited information about the firm's true value or future prospects, which may lead to market inefficiencies and mispricing. To overcome this information asymmetry, firms may use signaling to communicate their true value to potential investors. Receivers such as investors may interpret IPO-related signals alongside other observable cues, and the effects of one signal can attenuate or amplify those of others.
In spite of leaving money on the table, underpricing is still beneficial to the firm because it allows them to raise more capital than they would have if they had priced the shares at their true value, assuming a higher price at market close. This also helps to generate positive publicity and media attention for the issuer, providing further signaling for a company's positive growth prospects.
Additionally, firms can also signal their quality to the market through their choice of an underwriter. A reputable underwriter, such as a well-known investment bank, can signal that the issuing firm is of high quality and has a strong likelihood of future success. Considering the underwriter's role in providing due diligence and expertise in the IPO process, it is unlikely for an underwriter to associate themselves with firms that have a high likelihood of failure. This helps increase the credibility of the issuing firm, and hence the share capital on offer. Additionally, the underwriter's compensation structure, which is typically based on the success of the IPO, provides an incentive for the underwriter to ensure the success of the IPO. Therefore, by choosing a reputable underwriter, the issuing firm can signal its quality to potential investors, which increases the demand for its shares and can potentially lead to a higher aftermarket price.
However, while signaling mechanisms can benefit issuers, they can also impose costs on investors. Information asymmetry can make it difficult for investors to distinguish between true signals of quality and mere attempts to manipulate the market. Moreover, the use of signals can lead to a "winner's-curse" where investors overpay for shares that are not worth the price paid. Thus, understanding the costs and benefits of different signaling mechanisms is crucial in improving market efficiency and reducing information asymmetry problems.
Brands The development of brand capital is an important strategy firms use to signal quality and reliability to consumers. Waldfogel and Chen (2006) studied the impact of retailers providing information on internet retail sites to the importance of branding as a signalling mechanism. Their study used web visits to branded vendors, unbranded vendors and third party sites which took data and collated it for consumers labelled information intermediaries. The paper did not directly measure the outcome on consumer spending because it did not include actual consumer expenditure on branded or unbranded products. It further acknowledged there is the potential consumer spending deviates from visiting behaviour. Nonetheless, it found using information intermediaries increases the number of consumer visits to unbranded vendors while it also depresses visits to branded vendors. The authors concluded by observing that while branding is a market concentrating mechanism, the internet has the potential to result in reducing market concentration as information provision undermines the effectiveness of brand spending. In many markets, certifications and third-party endorsements can act as additional elements within a signaling system, shaping the perceived credibility of brand-related claims for consumers and other stakeholders. Signalling altruism is critical in human societies because altruism is a method of signalling willingness to cooperate. Studies indicate that altruism boosts an individual’s reputation in the community, which in turn enables the individual to reap greater benefits from reputation including increased assistance if they are in need. In games where voters were provided by the testers with a mitigating reason they could cite to the other person to explain their decision, 6:1 splits were much more common than fair 50:50 split.
Empirical research in real world scenarios shows charitable giving diminishes with anonymity. Anonymous donations are much less common than non-anonymous donations. They also found donations were subject to reference effects. Second, those who gave small donations were more likely to reveal their names but hide their donations. Average donors revealed name and amount to also gain reputation. Revealing amount values the authors thought is more consistent with the latter hypothesis. Recently, signalling theory has been applied in used cars market such as eBay Motors. Lewis (2011) examines the role of information access and shows that the voluntary disclosure of private information increases the prices of used cars on eBay. Dimoka et al. (2012) analyzed data from eBay Motors on the role of signals to mitigate product uncertainty. Extending the information asymmetry literature in consumer behavior literature from the agent (seller) to the product, authors theorized and validated the nature and dimensions of product uncertainty, which is distinct from, yet shaped by, seller uncertainty. Authors also found information signals (diagnostic product descriptions and third-party product assurances) to reduce product uncertainty, which negatively affect price premiums (relative to the book values) of the used cars in online used cars markets.
Internet-Based Hospitality Exchange In internet-based hospitality exchange networks such as BeWelcome and Warm Showers, hosts do not expect to receive payments from travelers. The relation between traveler and host is rather shaped by mutual altruism. Travelers send homestay requests to the hosts, which the hosts are not obligated to accept. Both networks as non-profit organizations grant trustworthy teams of scientists access to their anonymized data for publication of insights to the benefit of humanity. In 2015, datasets from BeWelcome and Warm Showers were analyzed. Analysis of 97,915 homestay requests from BeWelcome and 285,444 homestay requests from Warm Showers showed general regularity — the less time is spent on writing a homestay request, the less is the probability of being accepted by a host. Low-effort communication aka 'copy and paste requests' obviously sends the wrong signal. In a study published in the Journal of Economic Theory, a signalling model has been proposed that has a unique equilibrium outcome. In the principal-agent model it is argued that an agent will choose a large (observable) investment level when he has a strong outside option. Yet, an agent with a weak outside option might try to bluff by also choosing a large investment, in order to make the principal believe that the agent has a strong outside option (so that the principal will make a better contract offer to the agent). Hence, when an agent has private information about his outside option, signalling may mitigate the hold-up problem.
Foreign policy and international relations Due to the nature of international relations and foreign policy, signaling has long been a topic of interest when analyzing the actions of the agents involved. This study of signaling regarding foreign policy has further allowed economists and academics to understand the actions and reactions of foreign bodies when presented with varying information. Typically when interacting with one another, the actions of these foreign parties are heavily dependent on the proposed actions and reactions of each other. In many cases however, there is an asymmetry of information between the two parties with both looking to aid their own non-mutually beneficial interests.
Costly signaling In foreign policy, it is common to see game theory problems such as the prisoner’s dilemma and chicken game occur as the different parties both have a dominating strategy regardless of the actions of the other party. In order to signal to the other parties, and furthermore for the signal to be credible, strategies such as tying hands and sinking costs are often implemented. These are examples of costly signals which typically present some form of assurance and commitment in order to show that the signal is credible and the party receiving the signal should act on the information given.
Sinking costs and tying hands A costly signal in which the cost of an action is incurred upfront (ex ante) is a sunk-cost. An example of this would be the mobilization of an army as this sends a clear signal of intentions and the costs are incurred immediately.
When the cost of the action is incurred after the decision is made (ex post) it is considered to be tying hands. A common example is an alliance which does not have a large initial monetary cost yet ties the hands of the parties, as either party would incur significant costs if they abandoned the other party, especially in crises.
Theoretically both sinking costs and tying hands are valid forms of costly signaling however they have garnered much criticism due to differing beliefs regarding the overall effectiveness of the methods in altering the likelihood of war. Recent studies such as the Journal of Conflict Resolution suggest that sinking costs and tying hands are both effective in increasing credibility. This was done by finding how the change in the costs of costly signals vary their credibility. Prior to this research studies conducted were binary and static by nature, limiting the capability of the model. This increased the validity of the use of these signaling mechanisms in foreign diplomacy.
Effectiveness of signaling through time The initial research into signaling suggested that it was an effective tool in order to manage foreign economic and military affairs however, with time and more thorough analysis problems began to present themselves, these being:
- Whether or not the extent to which the signal is received and acted upon may not justify the cost of the signal
- Parties and those who govern them are able to signal in more ways than just through actions
- Different signals often provoke different responses from different parties (heterogeneity plays a large part in the effectiveness of signals)
In Fearon’s original models (Bargaining model of war) the model was simple in that a party would display their intentions, their intended audience would then interpret the signals and act accordingly. Thus, creating a perfect scenario which validates the use of signaling. Later in works by Slantchev (2005), it was suggested that due to the nature of using military mobilization as a signal, despite having intentions to avoid war can increase tensions and thus both be a sunk cost and can tie the party’s hands. Furthermore Yarhi-Milo, Kertzer and Renshon (2017) were able to use a more dynamic model to assess the effectiveness of these signals given varying cost levels and reaction levels.