In economics, more precisely in contract theory, signaling 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 signaling model, employees signal the level of their skills to employers by acquiring a certain degree of education. Economics (deriving from the Greek words οίκω [okos], house, and νέμω [nemo], rules hence household management) is the social science that studies the allocation of scarce resources to satisfy unlimited wants. ... Contract theory is the body of legal thought that investigates normative and conceptual problems in contract law. ... Look up Agent in Wiktionary, the free dictionary An agent is an autonomous entity with an ontological commitment and agenda of its own. ... A principal is: The head of an institution. ... Michael Spence is a winner of Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel, along with George A. Akerlof and Joseph E. Stiglitz, for their work on the dynamics of information flows and market development. ...

Introductory Questions

Signaling 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 interperet 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. In economics, information asymmetry occurs when one party to a transaction has more or better information than the other party. ... Perfect information is a term used in economics and game theory to describe a state of complete knowledge that is available to all market participants, or players, and that is instantaneously updated as new information arises. ... Michael Spence is a winner of Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel, along with George A. Akerlof and Joseph E. Stiglitz, for their work on the dynamics of information flows and market development. ...

• 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 an signaling 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 Signaling 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. A wage is the amount of money paid for some specified quantity of labour. ... In economics and business, the price is the assigned numerical monetary value of a good, service or asset. ...

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. Investment is a term with several closely related meanings in finance and economics. ...

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 signaling 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 signaling equilibrium.

Still To Come: Pooling and Separating Equilibria

References

Michael Spence (2002). "Signaling in Retrospect and the Informational Structure of Markets". American Economic Review 92 (3): 434-459.(also available as his Nobel Prize lecture) Photographs of Nobel Prize Medals. ...