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Signaling Theory
Before jumping right into signaling theory, let's have a quick refresher on asymmetric information. In every nook and corner around the world, the problem of asymmetric information is imminent. Asymmetric information is a situation when one party (such as a seller) in an economic transaction has more information about the goods and services than the other party (such as a buyer).
The theory of asymmetric information, which was developed in the 1970s, states that when there is an information gap about the goods and services between the seller and the buyer, it can lead to market failure. As the buyers don't have enough information, they are unable to distinguish between the low-quality product and the high-quality product. Hence, both high-quality and low-quality products can be sold at the same price.
Each market is unique and different types of asymmetric information situations might arise depending on the situation. In the case of the labor market, workers are more likely to know about their skills than the employer. Likewise, a product manufacturing company has better knowledge about its products than its customers.
Let's have a look at the example to comprehend the concept better.
Let's say Cristiano works eight hours a day at a construction site. He is aware that he can finish his task in half the time allotted to him and can spend the remaining time playing games. On the other hand, Cristiano's employer thinks that he needs eight hours to accomplish the task but is unaware of his capacity to work quickly. Hence, Cristiano is encouraged to work hard during the first half of the job and have fun during the second half because of the information gap between him and his employer.
Want to learn more about asymmetric information? Check out this article: Asymmetric Information.
Now that we are aware of the challenges caused by asymmetric information in the market, we will examine the strategy adopted by sellers and buyers to address this issue.
Signaling is one of the strategies commonly applied to address the issue of asymmetric information. The theory of signaling was developed by Michael Spence. It states that sellers send signals to consumers that assist them in judging the quality of the products. 1 The theory of signaling initially centered around job market signaling, in which employees used to send signals to employers with their education. Signaling is now also employed in marketplaces, where sellers give signals to buyers to help them determine the quality of their goods. 1
Signaling theory is useful when two parties (buyers and sellers) involved in the economic transaction have different levels of information about the product or service.
Several signaling techniques are used by sellers, depending on the type of product. For example, guarantees and warranties are used by many manufacturers of electronic goods as a signal to illustrate the reliability of the product.
Asymmetric information occurs when one party in an economic transaction is more adequately informed about the goods and services than the other party.
The signaling theory states that sellers provide buyers with signals to help them evaluate the quality of the products.
To learn more about Asymmetric information, do check out our article: Asymmetric Information
Signaling Example
Now, lets us comprehend the concept vividly using an example of signaling.
Let's assume Mitchell is the owner of a company that manufactures high-quality smartphones. Other manufacturers produce many different types of smartphones, ranging in quality from low to high. How can Mitchell set his products apart from those of low-quality smartphone producers in such type of situation?
To demonstrate how durable and long-lasting his smartphones are, Mitchell started to provide a one-year guarantee. Providing a guarantee is a very powerful signal to the customers as it enables them to differentiate between high-quality and low-quality products. Customers are aware that low-quality smartphone manufacturers are reluctant to offer their customers guarantees since the goods may have a variety of problems, and the manufacturer must repair them at their own cost. Therefore, Mitchell stands out in the market by providing a guarantee on his products.
Signaling Meaning
Let's try to understand the meaning behind signaling in a bit more detail. We know that one party sends signals to another party to demonstrate the reliability of the products or services they offer. Now, the question is, are the signals provided by one party strong enough to convince the other? Let's get straight into the labor market scenario to find out the types of signaling and how it works.
Suppose you own a company and are thinking of recruiting some new workers. In this case, workers are the sellers of the service, and you are the buyer. Now, how will you differentiate which worker is competent enough for the role? You might initially not know whether the workers are productive or not. This is where signaling from the workers helps a company in the recruitment process.
Workers send different types of signals, from dressing well in an interview to having good grades and a degree from a reputed university. Being well-dressed during an interview sends a weak signal because it doesn't significantly aid in separating high and low-productive workers. While on the other hand, having good grades from a reputed university signifies that the worker had put in a significant amount of effort while obtaining that degree, and hence the employee recognizes them as a highly productive worker.
Fig. 1 - Signaling meaning
Figure 1 depicts a company that recruits people depending on their years of education. According to the diagram, a greater year (four years) of education will be paid a higher salary of $100,000 because it indicates that an individual put in substantial effort to get the years of education and is capable of executing the firm's tasks successfully. Whereas a person with only two years of education is not deemed highly productive by a company and is paid less salary of $50,000.
A signal that isn't strong enough to convince the buyer to get into an economic transaction with the seller is known as a weak signal.
If the signal sent by one party can convince another party to come into an economic transaction, then it is regarded as a strong signal.
Do check out these articles to further flourish your knowledge of asymmetric information and its types!- Moral Hazard- The Principal-agent Problem
Signaling Importance
In economics, the importance of signaling is immense. The primary goal of signaling is to encourage someone to enter into an economic transaction or an agreement. In the market, there is always one party that has more information than another party about the product or service they provide. Signaling helps in the reduction of the information gap between the people involved in an economic transaction.
Moreover, signaling illustrates the firm's reliability and true intentions. If a company provides various types of signals to make consumers informed about their product, then the consumers might view that company as transparent and reliable. It also helps the company gain a competitive advantage in the industry they are operating in, as signaling helps to enhance customer satisfaction.
Assume Harry and David are both sellers of electric batteries. Harry recognizes the value of signaling and offers a six-month guarantee on his product, whereas David does not. Customers favored Harry's product over David's product due to signaling.
As a result, we can conclude that people prefer to buy your product over your competitor's simply because you give the correct type of signals.
- The importance of signaling is due to the following:- Reduces information asymmetry between sellers and buyers;- Illustrates the reliability of the product;- Helps firms to gain a competitive advantage.
Eager to explore more topics?
Why not click here:- Contract Theory- Adverse Selection
Signaling vs Screening
As we know, the problem of information asymmetry is seen in every market, and various efforts are made by parties involved in economic transactions to reduce it. Just like signaling, screening is one of the ways to reduce the problem of asymmetric information. Screening is the procedure by which one party induces another party to provide information about a product or service. In an economic transaction, one party screens another to determine the potential risk involved.
Assume you've decided to pursue a post-graduate degree at Harvard. The GPA and professional experience required to undertake the particular course are clearly stated by the university as they have less information about you. So, using your academic and professional experience, Harvard is conducting a screening test to determine whether you are qualified to take the course at the university.
The primary distinction between signaling and screening is that in signaling, the informed party provides information on their own, but in screening, the uninformed party forces an informed party to reveal information.
The process in which one party makes another party reveal information about a product or a service is known as screening.
Want to learn more about screening? Do check out our article: Screening.
Signaling - Key Takeaways
- Asymmetric information occurs when one party in an economic transaction is more adequately informed about the goods and services than the other party.
- The signaling theory states that sellers provide buyers with signals to help them evaluate the quality of the products.
- A signal that isn't strong enough to convince the buyer to get into an economic transaction with the seller is known as a weak signal.
- If the signal sent by one party can convince another party to come into an economic transaction, then it is regarded as a strong signal.
- The process in which one party makes another party reveal information about a product or a service is known as screening.
References
- Michael Spence (1973). "Job Market Signaling". Quarterly Journal of Economics. 87 (3): 355–374. doi:10.2307/1882010 https://doi.org/10.2307%2F1882010
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Frequently Asked Questions about Signaling
What is the signaling theory concept?
The signaling theory states that sellers provide buyers with signals to help them evaluate the quality of the products.
What is an example of signaling?
An example of signaling is guarantees and warranties used by many manufacturers of electronic goods as a signal to illustrate the reliability of the product.
What is signaling and screening in the context of asymmetric information?
The process in which one party makes another party reveal information about a product or a service is known as screening. On the other hand, signaling is the process in which one party sends signals to another party to demonstrate the reliability of the products or services they offer.
Why is the signaling theory important?
The theory of signaling is important because it helps sellers send signals to consumers that assist them in judging the quality of the products which ultimately helps in reducing asymmetric information.
What is the difference between signaling and screening in economics?
The primary difference between signaling and screening is that in signaling, the informed party provides information on their own, but in screening, the uninformed party forces an informed party to reveal information.
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