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.

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- [Professor Tyler Cowen] 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 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 the 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 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 Hyundai 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 consumer 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 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 earned 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 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 just about
giving your love one something beautiful?

Or is it also important the ring costs a
lot? What asymmetric information might

this signal help reveal? Here's another
one. Why do criminal tattoo their faces?

What might be the asymmetric information
problems 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 the 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 trades 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.

- [Announcer] If you want to test yourself,
click “Practice Questions.”

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