Signaling

A signal is an action that reveals information. Let’s look at higher education, for example. A large fraction of the value you receive from your degree comes on the day you earn your diploma. Your expected wages don’t increase with each class you complete along the way; instead, they spike sharply at the end when you receive your diploma. This is often referred to as the “Sheepskin Effect” because diplomas used to be printed on sheepskin.

Nobel Prize winner Michael Spence did research on this subject and found that education is valuable not necessarily because it creates valuable skills, but rather that it signals valuable skills. So how does the signal, represented by a degree, alleviate asymmetric information?

Employers don’t necessarily know how smart or skilled you are. Your degree, however, provides a credible signal of these traits and gives them more information they can use in the hiring process.

What other signals exist? We discuss examples like diamond engagement rings, why criminals tattoo their face, and why a peacock has a colorful tail. Let us know what examples you come up with in the comments.

Microeconomics Course: http://mruniversity.com/courses/principles-economics-microeconomics

Ask a question about the video: http://www.mruniversity.com/courses/principles-economics-microeconomics/signaling-economics#QandA

♪ [music] ♪

- [Professor Tyler] So how did
the Korean Hyundai

become such an excellent car,

and earn so much success
in the marketplace?

Well, let's go back in time.

In 1986, the first Hyundai Excel
was sold in the United States.

It was not entirely attractive,
but it was inexpensive.

The problem though was that
it just didn't work that well.

So Hyundais quickly
developed a reputation

for being lower quality cars,

and in time, they became the butt
of jokes among American consumers.

Jay Leno, who was at that time
was host of the Tonight Show

said that you could double
the value of your Hyundai

by filling it up with gas.

Hyundai wanted
to flip this reputation

and compete with the more
successful companies,

such as Honda and Toyota,
and they managed.

Hyundai decided they would invest
in new advanced factories,

in worker training,
and in quality control.

This, in turn, would result
in much higher quality cars.

But how could Hyundai
convince consumers

of this new higher quality --

quality that was maybe
difficult to see

unless you had owned the car
for a few years already.

Consumers didn't, in fact,
usually know what was going on

in Hyundai’s factories.

So again, we have a case
of asymmetric information,

where Hyundai knew much more
about the quality of its products

than did consumers.

So what could the company do?

Hyundai rolled out what it called
"America's Best Warranty."

The warranty assured consumers
that the cars were high quality,

and it got consumers
to start buying those cars.

What's great about this idea

is that it doesn't actually cost
Hyundai very much,

because the cars
were in fact high quality

and they didn't need to be
fixed all the time.

This Hyundai warranty
is an example of a signal.

A signal is an expensive action
that reveals information,

and for it to work, a signal
has to be credible.

In this case, if Hyundai cars
were still unreliable,

such a comprehensive warranty

would have been
extremely costly to Hyundai.

Consumers, therefore,
bought Hyundais

figuring that if the warranty
were so strong,

well, the company had to have
a lot of faith in its cars.

So how does a signal help alleviate
asymmetric information?

Hyundai knew their cars
were of high quality

but consumers didn't know.

The warranty was a credible signal

that conveyed information
to the consumers,

specifically information
about the quality under the hood,

that consumers otherwise
couldn't easily judge.

This signal gave consumers
the information necessary

to have enough confidence
to buy a Hyundai.

Indeed, this story
had a happy ending.

So where else
might we see signaling?

Well, let's consider a puzzle
in higher education.

If going to college was simply
all about learning skills,

then you would expect
that your expected wages

would steadily grow as you completed
more and more classes.

For instance, when you would get
halfway through with your degree,

you would get half
of the expected wage increase

from earning the degree.

In each class, you're learning
valuable skills

so your expected wages
should incrementally rise

with each class completed, right?

Well, wrong.

In fact, a large fraction
of the value of a degree

comes on the day you earn
your degree, and finish.

So rather than seeing
a steady increase

in your expected wage
as you go through college,

you have a sharp upturn
in that wage right at the end.

Again, when you finish.

This is called
the "Sheepskin Effect,"

because diplomas
used to be printed on sheepskin.

Additionally, we see people
who receive a degree in,

say, Art History,

and they take jobs that maybe
have little or nothing to do

with the history of art.

Yet these people
receive higher wages

than those without
a degree altogether.

Why?

Well, the learning of art history
may not be applicable to the jobs,

but it shows those people
have some kind of talent.

The signaling theory of education --

from Nobel Prize winner
Michael Spence --

is that education is valuable,

not only because
it teaches us things,

but also because it signals
worker quality.

There’s asymmetric information

between an employee
and a potential employer.

The employer doesn't know
how smart, determined,

or conscientious you might be.

A degree provides
a credible signal of these traits

and gives employers
more information

about possible hires.

Why is it credible?

Well, getting a degree
is harder for someone

who isn't as smart,
determined, or conscientious.

Here are some other signals
to think about.

Are diamond engagement rings

just about giving your loved one
something beautiful?

Or is it also important
that the ring costs a lot?

What asymmetric information
might this signal help reveal?

Here's another one.

Why do some criminals
tattoo their faces?

What might be the asymmetric
information problems

that they're trying to solve?

And signaling is not only
a human phenomenon.

Why does a peacock
drag around a large colorful tail

which might appear
to hinder its survival?

What kind of signal
might be going on there?

And to whom?

Check your intuitions
to these puzzles

in our practice questions
after this video.

So, now that we've covered

how signals can help overcome
asymmetric information,

you might wonder,
"Are signals always a good thing?"

It might seem wasteful
to spend four years at college,

or to spend two months’ salary
on a ring just to signal something.

Students might prefer to learn more

rather than spending so much time
jumping through hoops,

and it might be better
to buy something more practical

for a potential spouse
than just a ring.

While signals do create
some inefficiency,

they also generate benefits
by creating more information.

They help individuals in markets
realize gains from trade

by overcoming problems
of asymmetric information.

So if you've enjoyed this video --

well, give us a signal
and please let us know.

Drop us a note or leave
a suggestion for us.

Your feedback will help determine

how we produce
future videos and materials.

Thanks.

- [Narrator] If you want
to test yourself,

click "Practice Questions."

Or, if you're ready to move on,
just click "Next Video."

♪ [music] ♪