Signaling

… a core concept in Economic Analysis and Atlas102

MichaelSpenceConcept description

Tyler Cowen (reference below) defines signaling as an action that reveals information.

The Economist (reference below) describes signaling as a solution to one of the biggest sources of market failure: asymmetric information.

“Often the biggest problem facing sellers is how to convince buyers that what they are selling is as good as they say it is. This problem arises in situations where the qualities of the thing being sold cannot be observed easily by buyers, who thus fear that sellers may be conning them. In such situations, an answer may be for sellers to do something that shows they mean what they say about quality. This something is what economists call signalling.

“Going to a leading university might be worth far more for what it signals to prospective employers about your abilities than for what you learn as a student. Likewise, the fact that a firm is willing to spend a lot of money advertising its product may say far more about what it thinks of the product than any information included in the actual ad. To be useful, signals must impose more costs on those who use them to send false messages than any gains to be had from lying.”

Click for MRU video

Click for MRU video

Tyler Cowen (reference below, video on right) uses examples of academic credential, diamond engagement rings, why criminals tattoo their face, and why a peacock has a colorful tail. He explains:

“A signal is an action that reveals information. Let’s look at higher education, for example. A large fraction of the value you receive from your degree comes on the day you earn your diploma. Your expected wages don’t increase with each class you complete along the way; instead, they spike sharply at the end when you receive your diploma. This is often referred to as the “Sheepskin Effect” because diplomas used to be printed on sheepskin. Nobel Prize winner Michael Spence did research on this subject and found that education is valuable not necessarily because it creates valuable skills, but rather that it signals valuable skills. So how does the signal, represented by a degree, alleviate asymmetric information? Employers don’t necessarily know how smart or skilled you are. Your degree, however, provides a credible signal of these traits and gives them more information they can use in the hiring process.”

Practice questions

From http://www.mruniversity.com/node/318713, accessed 10 May 2016.

  1. True or False: If you were to drop out of college after attending for 3 years and completing 75% of all coursework, you could expect to earn about 75% of the college premium in the labor market.
Atlas topic, subject, and course

Asymmetric Information, Signaling, and Game Theory (core topic) in Economic Analysis and Atlas102 Economic Analysis.

Source

The Economist, Signalling, Economics A-Z, at http://www.economist.com/economics-a-to-z/s#node-21529634, accessed 8 May 2016.

Tyler Cowen, Signaling (7-minute video), Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/signaling-economics, accessed 10 May 2016.

Page created by: Ian Clark, last modified 10 May 2016.

Image: Tyler Cowen, Minute 0.15 of Signaling (7-minute video), Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/signaling-economics, accessed 10 May 2016.