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 SelectionSignalling 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 SignalsSeveral types of signals are used to address adverse selection.
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 SignalsTo 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. ScreeningAnother 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. 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 | Recommended Citation: SIGNALLING, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2025. [Accessed: December 18, 2025]. |
