Signalling (economics)

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In economics, more precisely in contract theory, signalling is the idea that one party (termed the agent) conveys some meaningful information about itself to another party (the [principal]). For example, in Michael Spence's job-market signalling model, employees signal the level of their skills to employers by acquiring a certain degree of education.

Contents

1 Introductory Questions
2 A Basic Job-Market Signalling Model

2.1 Assumptions and Groundwork
2.2 The Result

3 References
4 See also

Introductory Questions

Signalling took root in the idea of asymmetric information (a deviation from perfect information), 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 behavior 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 wage, or price. Generally, employers are willing to pay higher wages to employ better workers.

Assumptions and Groundwork

Spence began his 1973 model with a hypothetical. 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 really upset about this, because they get a free ride off of the hard work of the good employees. But good employees know that they deserve to be paid more for their effort, so they invest in the signal — in this case, some amount of education. Spence assumes that education doesn't enhance the employee's productivity at all. But he does make one key assumption: good-type employees pay less for one unit of education than bad-type employees.

The Result

Spence discovered that even if education didn't contribute anything to an employee's productivity, good employees would still buy more education in order to signal their higher productivity to employers. (Economists sometimes call this the signalling hypothesis in education, often cited as a reason why government should not subsidize higher education for workers: more education allows workers to be paid a higher wage but doesn't make society more productive.) Bad workers, for their part, would accept a lower wage rather than pay the higher price (for them) of getting more education. And employers, seeing that the education signal really is correlated to employee productivity, would condition their wages on the signal, offering better wages to those who had invested more in the signal. This is called a signalling equilibrium.

References

(also available as his Nobel Prize [lecture])