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Signalling (economics)
Encyclopedia
In economics
, more precisely in contract theory
, signalling (or signaling: see American and British English differences
) is the idea that one party (termed the agent) credibly conveys some information about itself to another party (the principal). For example, in Michael Spence's
job-market signalling model, (potential) employees send a signal about their ability level to the employer by acquiring certain education credentials. The informational value of the credential comes from the fact that the employer assumes it is positively correlated with having greater ability.
), which says that in some economic transactions, inequalities in access to information upset 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. That party would then interpret the signal and adjust her purchasing behaviour accordingly — usually by offering a higher price than if she had not received the signal.
There are, of course, many problems that these parties would immediately run into.
, or price
. Generally, employers are willing to pay higher wages to employ better workers. While the individual may know his or her own level of ability, the hiring firm is not (usually) able to observe such an intangible trait - thus there is an asymmetry of information between the two parties. Education credentials can be used as a signal to the firm, indicating a certain level of ability that the individual may possess; thereby narrowing the informational gap. This is beneficial to both parties as long as the signal indicates a desirable attribute - a signal such as a criminal record may not be so desirable.
Bad employees aren't upset about this, because they get a free ride
from the hard work of the good employees. But good employees know that they deserve to be paid more for their higher productivity, so they desire to invest in the signal — in this case, some amount of education
. Spence assumes that education does not increase the productivity of an individual. But he does make one key assumption: good-type employees pay less for one unit of education than bad-type employees. The cost he refers to is not necessarily the cost of tuition and living expenses, sometimes called out of pocket expenses, as one could make the argument that higher ability persons tend to enroll in "better" (i.e. more expensive) institutions. Rather, the cost Spence is referring to is the opportunity cost
. This is a combination of 'costs', monetary and otherwise, including psychological, time, effort and so on. Of key importance to the value of the signal is the differing cost structure between "good" and "bad" workers. The cost of obtaining identical credentials is strictly lower for the "good" employee than it is for the "bad" employee.
The differing cost structure need not preclude "bad" workers from obtaining the credential. All that is necessary for the signal to have value (informational or otherwise) is that the group with the signal is positively correlated with the previously unobservable group of "good" workers. In general, the degree to which a signal is thought to be correlated to unknown or unobservable attributes is directly related to its value.
The increase in wages associated with obtaining a higher credential is sometimes referred to as the Sheepskin Effect, 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 to 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.
One of the consequences of the existence of a pure signalling value to education is that public funding of education, especially higher education, is questioned. The debate is not so much about whether there should be any public funding at all; but what the correct level of funding should be. In purely economic terms, the optimal level of public funding would equal the total public benefits from the educated population - the private value of the signal would be excluded.
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
, more precisely in contract theory
Contract theory
In economics, contract theory studies how economic actors can and do construct contractual arrangements, generally in the presence of asymmetric information. Because of its connections with both agency and incentives, contract theory is often categorized within a field known as Law and economics...
, signalling (or signaling: see American and British English differences
American and British English differences
This is one of a series of articles about the differences between British English and American English, which, for the purposes of these articles, are defined as follows:...
) is the idea that one party (termed the agent) credibly conveys some information about itself to another party (the principal). For example, in Michael Spence's
Michael Spence
Andrew Michael Spence is an American economist and recipient of the 2001 Nobel Memorial Prize in Economic Sciences, along with George A. Akerlof and Joseph E. Stiglitz, for their work on the dynamics of information flows and market development. He conducted this research while at Harvard University...
job-market signalling model, (potential) employees send a signal about their ability level to the employer by acquiring certain education credentials. The informational value of the credential comes from the fact that the employer assumes it is positively correlated with having greater ability.
Introductory questions
Signalling took root in the idea of asymmetric information (a deviation from perfect informationPerfect information
In game theory, perfect information describes the situation when a player has available the same information to determine all of the possible games as would be available at the end of the game....
), which says that in some economic transactions, inequalities in access to information upset the normal market for the exchange of goods and services. In his seminal 1973 article, Michael Spence
Michael Spence
Andrew Michael Spence is an American economist and recipient of the 2001 Nobel Memorial Prize in Economic Sciences, along with George A. Akerlof and Joseph E. Stiglitz, for their work on the dynamics of information flows and market development. He conducted this research while at Harvard University...
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. That party would then interpret the signal and adjust her purchasing behaviour accordingly — usually by offering a higher price than if she had not received the signal.
There are, of course, many problems that these parties would immediately run into.
- How much time, energy, or money should the sender (agent) spend on sending the signal?
- How can the receiver (the principal, who is usually the buyer in the transaction) trust the signal to be an honest declaration of information?
- Assuming there is a signalling equilibrium under which the sender signals honestly and the receiver trusts that information, under what circumstances will that equilibrium break down?
A basic job-market signalling model
In the job market, potential employees seek to sell their services to employers for some wageWage
A wage is a compensation, usually financial, received by workers in exchange for their labor.Compensation in terms of wages is given to workers and compensation in terms of salary is given to employees...
, or price
Price
-Definition:In ordinary usage, price is the quantity of payment or compensation given by one party to another in return for goods or services.In modern economies, prices are generally expressed in units of some form of currency...
. Generally, employers are willing to pay higher wages to employ better workers. While the individual may know his or her own level of ability, the hiring firm is not (usually) able to observe such an intangible trait - thus there is an asymmetry of information between the two parties. Education credentials can be used as a signal to the firm, indicating a certain level of ability that the individual may possess; thereby narrowing the informational gap. This is beneficial to both parties as long as the signal indicates a desirable attribute - a signal such as a criminal record may not be so desirable.
Assumptions and groundwork
Spence began his 1973 model with a hypothetical example. Suppose that there are two types of employees — good and bad — and that employers are willing to pay a higher wage to the good type than the bad type. Spence assumes that for employers, there's no real way to tell in advance which employees will be of the good or bad type.Bad employees aren't upset about this, because they get a free ride
Free rider problem
In economics, collective bargaining, psychology, and political science, a free rider is someone who consumes a resource without paying for it, or pays less than the full cost. The free rider problem is the question of how to limit free riding...
from the hard work of the good employees. But good employees know that they deserve to be paid more for their higher productivity, so they desire to invest in the signal — in this case, some amount of education
Education
Education in its broadest, general sense is the means through which the aims and habits of a group of people lives on from one generation to the next. Generally, it occurs through any experience that has a formative effect on the way one thinks, feels, or acts...
. Spence assumes that education does not increase the productivity of an individual. But he does make one key assumption: good-type employees pay less for one unit of education than bad-type employees. The cost he refers to is not necessarily the cost of tuition and living expenses, sometimes called out of pocket expenses, as one could make the argument that higher ability persons tend to enroll in "better" (i.e. more expensive) institutions. Rather, the cost Spence is referring to is the opportunity cost
Opportunity cost
Opportunity cost is the cost of any activity measured in terms of the value of the best alternative that is not chosen . It is the sacrifice related to the second best choice available to someone, or group, who has picked among several mutually exclusive choices. The opportunity cost is also the...
. This is a combination of 'costs', monetary and otherwise, including psychological, time, effort and so on. Of key importance to the value of the signal is the differing cost structure between "good" and "bad" workers. The cost of obtaining identical credentials is strictly lower for the "good" employee than it is for the "bad" employee.
The differing cost structure need not preclude "bad" workers from obtaining the credential. All that is necessary for the signal to have value (informational or otherwise) is that the group with the signal is positively correlated with the previously unobservable group of "good" workers. In general, the degree to which a signal is thought to be correlated to unknown or unobservable attributes is directly related to its value.
The result
Spence discovered that even if education did not contribute anything to an employee's productivity, it could still have value to both the employer and employee. If the appropriate cost/benefit structure exists (or is created), "good" employees will buy more education in order to signal their higher productivity.The increase in wages associated with obtaining a higher credential is sometimes referred to as the Sheepskin Effect, 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 to 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.
One of the consequences of the existence of a pure signalling value to education is that public funding of education, especially higher education, is questioned. The debate is not so much about whether there should be any public funding at all; but what the correct level of funding should be. In purely economic terms, the optimal level of public funding would equal the total public benefits from the educated population - the private value of the signal would be excluded.
Signalling and IPOs
Leland and Pyle (1977) analyse the role of signals within the process of IPO. The authors show how companies with good future perspectives and higher possibilities of success("good companies") should always send clear signals to the market when going public (e.g. the owner should keep control of a significant percentage of the company). To be reliable, the signal must be too costly to be imitated by "bad companies". If no signal is sent to the market, asymmetric information will result in adverse selection in the IPO market.See also
- CountersignallingCountersignalingCountersignaling or countersignalling is the behavior where agents with the highest level of a given property invest less into proving it than individuals with a medium level of the same property...
- Impression managementImpression managementIn sociology and social psychology, impression management is a goal-directed conscious or unconscious process in which people attempt to influence the perceptions of other people about a person, object or event; they do so by regulating and controlling information in social interaction...
- Stigma managementStigma managementWhen a person receives unfair treatment or alienation due to a social stigma the effects can be detrimental. Social stigma can be defined as any aspect of an individual’s identity that is devalued in a social context . For some individuals, a stigma can be invisible to others, leading to an...
- Signalling game