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SCARCITY RENT: The marginal opportunity cost imposed on future generations by extracting one more unit of a resource today. Scarcity rent is one of two costs the extraction of a finite resource imposes on society. The other is marginal extraction cost--the opportunity cost of resources employed in the extraction activity. Scarcity rent is the cost of "using up" a finite resource because benefits of the extracted resource are unavailable to future generations. Efficiency is achieved when the resource price--the benefit society is willing to pay for the resource today--is equal to the sum of marginal extraction cost and scarcity rent.

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SIGNALLING:

When confronted by asymmetric information, the use of small bits of information, or indicators, that suggest more comprehensive information. Signalling is used by those with more information to reduce the cost of informing those with less information. It is commonly used in markets with adverse selection. Methods of signalling include advertising, brand names, and warranties. A related method is screening.
Signalling is one method of addressing the problems associated with asymmetric information, especially adverse selection and the market for lemons. When asymmetric information limits the exchange of higher quality products, those who supply these products seek to provide low cost bits of information to the buyers. Because the buyers cannot justify the expense of searching out the information, the sellers offer low cost information signals through such things as advertising, brand name recognition, warranties, and guaranties.

Signals can be an effective, but imperfect way of addressing adverse selection. Unfortunately those selling lower quality products often try to mimic these signals. This confuses the situation and reduces the effectiveness of signalling. If signals fail to differentiate high quality goods from low, then they don't work.

Screening is a related method of addressing the problems of asymmetric information. Screening arises when those with less information use indicators to differentiate product quality. Whereas signalling is undertaken by those with more information, screening is used by those with less.

Adverse Selection

Signalling is used when asymmetric information leads to adverse selection. Adverse selection is an inefficient, bad, or adverse outcome of a market exchange that results because buyers and/or sellers make decisions based on asymmetric information. Buyers, confronted with less information than sellers are inclined to offer an average price, which excludes higher quality products from the market.

The way to correct adverse selection is to provide more information to the buyers. Unfortunately, the reason buyers have less information is that an efficient search balance between the benefits and costs don't justify more. Signalling addresses this by reducing the cost of information. The information is not as good nor is it as complete, but it is better.

Common Signals

Several types of signals are used to address adverse selection.
  • Advertising: An effective means of providing low cost information to buyers is through advertising. Advertising ranges from mass communication television commercials to one-on-one sales pitches. While advertising seeks to persuade buyers as much as anything, it also provides low cost information. In most cases buyers take no action, incur no cost, need no search effort. The information comes to them.

  • Brand Names: Sellers also provide signals by establishing well-recognized brand names. Some of this is accomplished through advertising, but it also comes from consistently providing a high quality product over a period of time. Less informed buyers can use the brand name as a signal of product quality, especially if it is attached to a new, yet untried product.

  • Warranties: To assure a low information buyer of high product quality, a seller might be inclined to offer a warranty or guarantee with the product. If the product does not meet with the buyer's quality expectations, then the seller might offer a refund, replacement, or some other correction. The existence of such a warranty is intended to signal the buyer of the product quality.

  • Characteristics: The quality of a product can also be indicated by a limited number of key characteristics. Information about these characteristics can be more easily provided to buyers than complete information. One characteristic is suggestive of other high quality characteristics of the product.

  • Associations: Another signal of product quality is who or what is commonly associated with the product. If the product is used in specific circumstances or by specific people that demand a high quality product, then a signal is passed along that the product is high quality.
The sellers of most consumer products, ranging from automobiles to pharmaceuticals to kitchen appliances to video games to burial services, use or all of these methods of signalling. The OmniMotors car company, for example, undertakes a lot of commercial advertising using all forms of media (television, radio, newspapers, magazines, the Intenet, billboards, blimps, movie theater trailers, and sports arenas). It has also worked hard at promoting the OmniMotors brand, making certain that it does not allow any inferior quality products to carry the OmniMotors name. It offers an extensive 10-year warranty on all new OmniMotors cars sold, a sign that it is willing to back up product quality claims. Further, it promotes key characteristics of its cars, such as rack and pinion steering, antilock braking system, and turbo charged engine that are associated with high quality cars. Lastly, it features only the most popular entertainers, like Brace Brickhead, in its commercials. If Brace Brickhead drives and OmniMotors, then so should you.

Prospective employees, who know what they can do, seeking to sell their services to employers, who probably don't, also use signals. They advertise themselves through resumes and interviews. They emphasize characteristics, such as grade point average, suggesting the potential quality of their work. And they emphasize school affiliation, membership in clubs, even friends and colleagues to indicate their quality.

False Signals

To the extent that signals are an effective means of relaying information of (high) product quality from high information sellers to low information buyers, they also can be misused by low quality sellers. If advertising, brand name recognition, warranties, characteristics, and associations can convince buyers that higher quality products deserve higher prices, then sellers of lower qualities products are bound to imitate this success.

The seller of a lower quality product is motivated to undertake competitive advertising, establish an analogous brand name, offer a comparable warranty, highlight seemingly similar characteristics, and note equivalent associations. None of this, however, changes the product quality.

The existence of false signals does nothing but muddy up the informational waters, effectively negating signals offered by high quality sellers. The more false signals, the muddier the waters. The buyers do not know who or what to believe. This works out well for the low quality sellers as the problems of adverse selection re-emerge and once again only the low quality products are exchanged.

Screening

Another technique used to counter the problems of asymmetric information is screening. Screening occurs when those with limited information try to identify indicators suggesting more complete information. Employers, for example, commonly use grade point averages, aptitude tests, or school quality as a means of screening out high quality from low quality prospective employees.

Whereas signalling is a means of providing information from those with high information to others with low information, screening works in the opposite way. It is a means by which those with low information seek information from those with high information.

Because a low information buyer is not able to know all that they need to know about a product, they attempt to differentiate among classes of products based on a limited number of indicators. They screen out the lower quality from the higher quality.

Does the product have high quality metal parts or low quality plastic parts? Is the student from a reputable school? Is the product sold by a company that's been in business for a long time? Does the student have a grade point average above 3.5?

Answers to these and a myriad of other questions can be used to screen out the good from the bad, the high quality from the low.

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Recommended Citation:

SIGNALLING, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2017. [Accessed: August 21, 2017].


Check Out These Related Terms...

     | screening | adverse selection | economics of information | information | information search | asymmetric information | moral hazard | principal-agent problem | rational ignorance | market for lemons |


Or For A Little Background...

     | scarcity | efficiency | sixth rule of ignorance | production | consumption | opportunity cost | scarce resources | market |


And For Further Study...

     | public choice | innovation | good types | market failures | financial markets | institutions | rational abstention | risk | uncertainty | risk preferences | risk aversion | risk neutrality | risk loving | marginal utility of income |


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