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Screening And Signaling

Suppose that John wants to sell a car that he values at $5000. Henry is looking for a car and would consider John's car worth $6000 if he knew as much about it as John knows. An exchange would benefit both Henry and John but it might not take place because of an information problem. John probably knows a variety of things about his car that might not be obvious to a buyer. But how can Henry trust John to tell him all that he knows when John has the incentive to misrepresent the quality of the car?

Economists say that the potential transaction described above has the problem of asymmetric information, which simply means that the information available to buyers is different than the information available to sellers. They are interested in this problem because they see it in many different situations and because it may lead to a market failure, a case in which a market is economically inefficient. However, when there is unexploited value, buyers and sellers have an incentive to find ways to capture that value. Sellers with high quality products need ways to signal the quality of their products so that buyers can distinguish between high-quality and low-quality products. Buyers must find ways to screen out erroneous information but allow in truthful information. These problems do not exist in markets in which products are simple and easily evaluated. There is little need for this behavior in many agricultural markets, for instance.

One way a seller can signal the quality of its product is by offering guarantees or warranties. If a firm offers a warranty on a poor product, it will suffer a loss. Therefore, it is in the firm's interests to only offer a warranty on a quality product. The warranty tells potential buyers that the firm will stake money on its belief that it has a good-quality product.

Another way a firm can signal quality is by building a brand name. A brand name is valuable only if consumers associate it with quality, and the firm can build this association only with time and resources. Once a brand name is established, it is in the interests of the firm to protect it by not offering a poor-quality product with its brand name. When a firm with an established brand name does offer a poor-quality product, it usually puts a different name on the product so as not to endanger the public's perception of its brand name.

Signaling plays an important role in the labor market. An employer has little information about a prospective employee, and cannot expect truthful answers if he asks whether the applicant is intelligent, has leadership qualities, and is responsible. Instead the applicant must try to prove that he has these qualities. A college education is a way of signaling intelligence and perseverance. Leadership can be signaled by extracurricular activities. (As a result, some students seek leadership positions primarily for their value as ways to signal leadership to future employers.) The purpose of a resume is to list those activities that will signal attractive qualities to potential employers.

The fact that a college education can signal qualities to employers has raised some interesting questions about why people get college educations. A popular answer among economists has been that education builds human capital, that is, it is a way of investing in people to increase their productivity. More recently some economists have suggested that this view is wrong or at best only partly true, and that college education mostly serves as a way of signaling to future employers. If education is merely a way of signaling, if it is only a complex gauntlet that eliminates those who are not intelligent and do not have perseverance, then the social usefulness of college education may not be very great. From the viewpoint of the student, it does not matter--the benefits are the same either way. Although most economists believe that education both builds human capital and acts as a signal, the relative importance of these two functions is still disputed.

Signaling is an action by a party with good information that is confined to situations of asymmetric information. Screening, which is an attempt to filter helpful from useless information, is an action by those with poor information. When two people go on a blind date, both are unsure if they are compatible, so both are screening, listening and watching to learn if the other person is someone with whom they would want a second date. (It is possible that both may be signaling as well, because each has information that the other does not have.)

There are many examples of screening in employment decisions. Employers give aptitude tests and check letters of recommendation. The existence of "old-boy" networks is the result of a screening process. If a person wants to hire someone, he will ask those he trusts (the "old boys") for recommendations. Because recommending someone who is unqualified will lower his prestige in the eyes of the other "old boys," there is an incentive for a person to only recommend qualified applicants.1 Also, part of the enthusiasm that employers have for graduates of prestigious MBA programs is that the schools are selective about who they let in. They try to select only those students who have the right combinations of intelligence and personality traits to ensure success in the business world. Thus, prestigious MBA programs act as a screening agency for business. This, as much as what they teach their students, may account for the high salaries their graduates command.

When there is asymmetric information in the market, screening can involve incentives that encourage the better informed to self-select or self-reveal. For example, a job with a low-paying probationary period will discourage those who know they are not well-suited for the position from applying. People who are confident that they will survive the probationary period are more likely to find the offer attractive than those who doubt their ability. A lender who demands collateral for a loan discourages applications from those who doubt their ability to repay. (Collateralized loans do more than screen, but screening is one of their functions.) People who expect to use insurance find deductibles more of a burden than those who do not expect to make claims. Hence, insurance companies use deductibles to sort policyholders into different risk classes and charge accordingly.

In the discussion of efficiency we considered the case in which a bundle of resources had three possible uses: one valued at $25, one at $22, and one at $20. We concluded that an efficient market sent those resources to the place where they were worth $25. Suppose, though, that this use has an information problem, so the seller must spend $5 to signal to the buyers that the product really is worth $25. Will the resources go to the most valuable use?

Next we begin a discussion of risk and uncertainty.

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1Of course, this "old boy" system makes it very difficult for qualified applicants outside the system to get in. The existence of the problems that make signaling and screening necessary tends to protect those who are already established.

Copyright Robert Schenk