Signaling Against Asymmetric Markets

Aug 12, 2021

Many of us have bought a used car. The experience is not especially fun. Not to say there aren't good used cars to find – my first car was a '98 Nissan Maxima with 150,000 miles on it, but it ran like a charm. There are also lemons. The lemons look good and might even drive off fine, but a week later – they stop working. The used car negotiation is a battle of information asymmetry.

Buyers want a discount because they don't know whether the car will need significant maintenance in the future or if it's a lemon. But sellers know precisely which kind of car they have. Sellers who have good cars won't be willing to sell at a discount and leave the market without other mechanisms. As a result, the average quality of used cars goes down, and a positive feedback loop. We're stuck with lemons.

The market for lemons is an example of adverse selection – when participants selectively engage in transactions where they have asymmetric information. For example, when you apply for a job, you have much more information about yourself than the employer. Say you're the perfect fit for the role: you are proficient in Microsoft Word. Everybody puts that on their resume, so the employer can't know for sure. Since they don't know for sure, they need to hedge their bets and can't offer you the total salary you deserve. How does this problem get fixed?

One method is called signaling theory, developed by Mike Spence, winner of the Nobel Prize in economics for his work in information theory and a professor at my alma mater, Stanford GSB. He proposed that signaling information could level the playing field in markets with information asymmetry.

How does signaling impact the job market? Let's say there are two types of employees – good" and bad. Employers are willing to pay more for good than bad ones, but they can't tell ahead of time. This risk means that the good employees are underpaid, and the bad employees are overpaid. Good employees can earn more by sending an observable signal – in many cases, education or credentials. Good employees have lower opportunity costs to get these credentials.

The question remains – can we find more credible and correlated signals for the labor market than education? Certainly, boot camps, income-share agreements, and alternatives to college will change the future of education.

Signals are one solution to adverse selection. Understand what signals you can send in your work to separate you from the rest.

For the curious, Mike Spence's 1973 paper, Job Market Signaling.