Signaling (economics)

In contract theory, signaling (or signalling: 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 education credentials. The informational value of the credential comes from the fact that the employer believes the credential is positively correlated with having greater ability and difficult for low ability employees to obtain. Thus the credential enables the employer to reliably distinguish low ability workers from high ability workers.

Self-signalling is a form of signalling that conveys information about an actor to herself. Betting that a team will win or lose can send a signal to the bettor about her own identity (e.g., serve as an indicator that she is or is not a fan of that team).

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 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.

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. 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.

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