SIGNALING TO CONVEY PRIVATE INFORMATION

Although asymmetric information is sometimes a motivation for public policy, it also motivates some individual behavior that otherwise might be hard to explain. Markets respond to problems of asymmetric information in many ways. One of them is signaling, which refers to actions taken by an informed party for the sole purpose of credibly revealing his private information We have seen examples of signaling in previous chapters. As we saw in Chapter 17, firms may spend money on advertising to signal to potential customers that they have high-quality products. As we saw inChapter 20, students may earn college degrees to signal to potential employers that they are high-ability individuals. Recall that the signaling theory of education contrasts with the human-capital theory, which asserts that education increases a person’s productivity, rather than merely conveying information about innate talent. These two examples of signaling (advertising, education) may seem very different, but below the surface, they are much the same: In both cases, the informed party (the firm, the student) is using the signal to convince the uninformed party (the customer, the employer) that the informed party is offering something of high quality What does it take for an action to be an effective signal? Obviously, it must be costly If a signal were free, everyone would use it, and it would convey no· information. For the same reason, there is another requirement: The signal must be less costly, or more beneficial, to the person with the higher-quality
product. Otherwise, everyone would have the same incentive to use the signal, and the signal would reveal nothing.

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