Signaling (economics)

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Signaling is part of the information economy and tries to solve the problems of the principal-agent theory . The agent has more information about an issue than the principal and therefore tries to send signals to the principal that reduce his uncertainty and induce him to conclude a contract. The aim is to prevent adverse selection and to produce a market result that is satisfactory for both sides. Michael Spence , who published his theory on the labor market in 1973, founded this theory .

Basic idea

So that sellers of high-quality products do not have to leave a market through adverse selection , they must signal to the customer that their product is better than that of the competitor. A common example is the used car market . When buying a car, car buyers ( principals ) do not know about its exact condition and are therefore afraid of being cheated by the seller ( agent ) when buying a car and thus paying significantly too much money. However, if the seller offers a guarantee for several years, he sends the buyer a signal of the high quality of the product. It would be quite expensive to offer such a guarantee on a low-quality product as there is a high likelihood that it will be used.

This basic idea can be applied to a great many economic issues and offers a solution to the problem of asymmetrical information for both sides . Michael Spence first formulated this concept in the early 1970s using the labor market. If the principal really wants to learn something about the agent (signal sender), there must be a difference in the economic net benefit of sending a signal. In relation to the example, this means that it is significantly cheaper for a manufacturer of a higher-quality product to issue a guarantee than for a manufacturer of a lower-quality product, since the guarantee would be used much less often.

Spence's labor market model

Basic model

Spence's 1973 model relates to the labor market as there are large information asymmetries here. The information on the labor market between employer and employee is unevenly distributed, which is why the employer has an information disadvantage compared to the applicant. If he wants to hire someone new, he does not yet have sufficient knowledge of the applicant's abilities at this point. The model assumes that there are two different types of workers, namely more productive and less productive. The share of workers in more productive and less productive workers is 50% each. Furthermore, companies produce with full competition and therefore make no profit.

The problem for the more productive workers is that without signaling the employer cannot tell them apart from a less productive one. This assumption is certainly exaggerated due to probationary periods and assessment centers , but it reflects the problem very well. From this point of view, an equilibrium wage arises, which lies between the wages of the more productive and the less productive worker. This is unsatisfactory for the more productive worker, so he will try to signal his higher productivity to the employer. He does this on the basis of a degree. The basic idea of ​​Spence is simple: The training will mean less effort, i.e. lower costs, for the more productive of the two workers and is therefore more worthwhile. For this reason, signaling can be brought about for the employee, in which he can signal his competencies .

Mathematical consideration

Data of the model

group Marginal product Training costs per year
More productive workers 2 K / 2
Less productive workers 1 K

It is assumed that more productive workers are twice as productive and that the cost of training (K) for this group is halved per year. The information in the table shows that the cost of fully training the less productive worker is twice as high as that of the more productive worker. Because of the higher added value, the employer is willing to pay the employee a higher wage. A more productive worker must, however, be able to distinguish himself from the less productive in order to be able to demand a higher salary. The employer pays a total premium (B) for everyone who has a university degree. For a university degree to be worthwhile, the net benefit (NB) from the degree must be greater than 0.

For productive workers:

NB more productive workers = BC more productive workers > 0
NB more unproductive workers = B- C more unproductive workers <0

A degree is only worthwhile for more productive employees, but not for less productive employees. He will decide against studying because the costs are too high. A more productive worker can do signaling and convince the employer of his skills.

Combating Market Failures

Due to information asymmetries, adverse selection can occur again and again in a market, which is why suppliers and buyers are displaced from the market. This leads to market failure . When buying a used car, buyers do not know the exact condition, which is why they are not prepared to pay more for a possibly better quality car than for a bad one. This displaces providers of good quality cars from the market.

George A. Akerlof also speaks of a " Market for Lemons ", in which cars of poor quality are called Lemons (" Monday cars") and cars of good quality are called Plums ("Quality cars "). Signaling is one way of avoiding market failure, as the better informed now have the opportunity to send a signal that brings trust and more information to the principal and thus avoids adverse selection. However, there are also costs for signaling, which is why there is only a second-best solution. The benefit from signaling must always be greater than the costs, otherwise the market will continue to fail.

Example: health insurance market

In the health insurance market too, information asymmetries lead to adverse selection and thus to market failure. Insured persons are better informed about their own risk of illness than insurers, which is why insurance companies would have to charge a price that would be too expensive for healthy patients. As a result, they might withdraw from the insurance market or take out private insurance. A possible solution for health-conscious people would be to operate signaling and, for example, present their medical records.

However, private health insurances do not lead to an optimal risk allocation. A seriously injured person would certainly not be denied treatment if he had no money for it. There is therefore no incentive for poorer households to take out private health insurance. This so-called free rider behavior means that fewer and fewer people are insured. As a result, the taxes to finance social benefits increase, which in turn means less insurance and more people rely on free treatment. The solution is therefore mandatory statutory health insurance that is mandatory for everyone. This solves both the problem of adverse selection and the problem of free rider behavior.

More signals

Signals can be applied to any type of economic relationship:

  • A guarantee distinguishes a good of high quality.
  • A person's lifestyle and the goods they consume are signals about their personality that would otherwise not be easy to see through.
  • Clothing at work can say something about the position you are in or how you want to appear in front of your clients and colleagues.
  • The consumption of expensive goods can provide the environment with information about a person's wealth and preferences.
  • With a commercial, the manufacturer can send a signal to the customer that he has to produce excellent products due to the high prices and that the company will be successful, as otherwise it would not be able to afford this expensive advertising.
  • Labels that stand for a certain quality, such as " Stiftung Warentest " or "Bio", can also give the consumer information about the good quality of the product.

All in all, all signaling examples are always about reducing information asymmetries and being able to give all actors more information and thus more trust.

Individual evidence

  1. ↑ http://wirtschaftslexikon.gabler.de/Definition/informationsoekonomik.html
  2. ↑ Hal Varian: Fundamentals of Microeconomics. De Gruyter Verlag, Berlin 2016, p. 830
  3. ↑ Austan Goolsbee , Steven Levitt , Chad Syverson: Microeconomics . Translated from American English by Ulrike Berger-Kögler, Reiner Flik, ​​Oliver Letzgus and Gerhard Pfister. Schäffer-Poeschel Verlag, Stuttgart 2014, pp. 813f.
  4. ↑ Eberhard Feess: Microeconomics - A game theory and application-oriented introduction. Metropolis Verlag, Marburg 2004, p. 635
  5. ↑ Austan Goolsbee, Steven Levitt, Chad Syverson: Microeconomics. Translated from American English by Ulrike Berger-Kögler, Reiner Flik, ​​Oliver Letzgus and Gerhard Pfister. Schäffer-Poeschel Verlag, Stuttgart 2014, pp. 815–817
  6. ↑ Hal Varian: Fundamentals of Microeconomics. De Gruyter Verlag, Berlin 2016, pp. 821–823
  7. ↑ Health insurance p. 4.
  8. ^ Organization and reform of the statutory health insurance in the Federal Republic, pp. 63f.
  9. ^ A b Austan Goolsbee, Steven Levitt, Chad Syverson: Microeconomics. Translated from American English by Ulrike Berger-Kögler, Reiner Flik, ​​Oliver Letzgus and Gerhard Pfister. Schäffer-Poeschel Verlag, Stuttgart 2014, pp. 820f.
  10. ↑ Transparency and competition p. 55