Signaling Theory – An Introduction

Signaling, as per Wiki, is defined as

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).

(Advanced economics students might want to classify this under behavioral economics).

Back in 1974, Nobel laureate Michael Spence introduced the notion of signaling in economic thinking. According to him, when information is imperfect, individuals who possess strong qualities will send signals to distinguish themselves from the others. He takes education as an example. Suppose there are two types of individuals called, for convenience, the ‘dafts’ and the ‘defts’. Employers cannot say who is who. It costs to the dafts more time and effort to become educated than to the defts. Spence shows that, if education is sufficiently costly for dafts and cheap for defts, only defts will invest in education, thereby signaling their higher productivity to potential employers.

Like it nor not, we all use signaling in our day-to-day lives. If I exaggerate a wee bit, it is used probably at every moment and with everyone. For example:

a. Business: Suppose you come up with a product – let’s say ‘Ketchup’. This Ketchup might be the best ketchup available in the country, if not the entire world. However, shouting-from-rooftops about this ketchup being the best in the world in various advertisements wouldn’t help much, since the Ketchup marketplace is already a crowded one. ‘Tastier than Heinz’ is one approach – relative comparison which customers will quickly catch on to – that’s one type of signaling. The second type of signaling might involve money back guarantees, public tasting guarantees or tying up with a food chain and offering your ketchup as a free add-on. Positive signaling to increase your business.

b. Corporations: This theory works very well during or near Quarter result declarations. Statements like ‘Retail sales are holding’, ‘Economy has been weak’ implies that earnings would not meet expectations. As also, is the case with dividends (giving out dividends consistently may be taken as stable company but no growth prospects), insider buying (when management of the company starts buying shares, it is usually a signal that the company is and will be doing well in the foreseeable future), insider selling (opposite of the previous item) and various other corporate actions – each signaling or telling us what is about to come. They may not be 100% reliable, but works most of the time.

c. Money: How do you let the world know that you are rich? One way, although incredibly crazy would be to print out your bank statements and put it up on a billboard. More often than not, in this case, you are sending out a positive signal for kidnappers! On a serious note, flaunting a Louis Vuitton bag, driving a Porsche car, building a huge house etc. are signals to indicate you are rich. You need not say anything, but your actions speak for it. That’s signaling.

d. At work: ‘Pretending to be busy’, ‘Blocking calendars’ and ‘looking perturbed and disturbed’ are all classic signals to indicate that you are someone important, your time is important and you deal with multiple issues in the corporation, even though you might not be. Trying to hang out with superiors is also a classic signal that you intend to move up the ladder. There are about a million examples of Signaling theory at work.

e. Relationships: Last but not the least, signaling theory works brilliantly in relationships. Does ‘Silence’ ring a bell? ‘What happened dear?’ might be a question posed to you. If you are silent or even worse, say ‘nothing’, then it’s a classic signal that you are pissed off at something he/she had done. I presume almost everyone in a relationship would have a gone through this exact example. That’s signaling at work – indicating to him/her that he/she better not repeat the act again.

Since this was only an introduction to the signaling theory, I restricted it to very simple and straightforward signals that we observe in daily life. There are more nuanced signals and then there are counter-signals in almost every walk of life, through which we can learn a lot about a business/corporation/person/relationship. I will try to point to certain examples and explain these signals in the near future.

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