Signalling (economics)

Signalling (or signaling; see spelling differences) is a theory of decision-making and communication under imperfect or incomplete information. It describes situations in which a signaler uses observable actions, attributes, or communications (signals) to convey credible information about otherwise unobservable qualities to a receiver. Signals are most credible when they are differentially costly (i.e., harder or more expensive for low-quality signalers to produce or imitate than for high-quality signalers).

Signaling theory is about decision-making and communication under incomplete information. It describes situations in which signalers send observable actions, attributes, or communications that carry credible information about unobservable qualities that matter for a receiver’s choice. Signals are most informative when they are differentially costly, meaning they are highly costly for low-quality signalers and less costly for high-quality signalers. In many applications, the signaling system is analysed in terms of the signaler, the signal, the receiver, and the costs embedded in producing, maintaining, or imitating the signal. Costs may include direct production costs, penalties for false or misleading signaling, and “reaction costs” that arise when unintended audiences respond negatively to a signal intended for someone else. Signals can also be sent unintentionally, so observable behaviour may still inform receiver decision-making even when it was not designed as deliberate communication.

Signalling was briefly introduced and discussed in the seminal Theory of Games and Economic Behavior, which is considered to be the text that created the research field of game theory.

Signaling theory was more fully developed by Michael Spence, specifically in the context of observed knowledge gaps between organisations and prospective employees. However, its intuitive nature led it to be adapted to many other domains, such as Human Resource Management, business, and financial markets. Later reviews emphasise additional actors and complexities in signaling systems (including broader stakeholder audiences) and propose directions for future theory development.

In Spence's job-market signaling model, (potential) employees send a signal about their ability level to the employer by acquiring education credentials. The informational value of the credential comes from the fact that the employer believes the credential is positively correlated with having the greater ability and difficult for low-ability employees to obtain. Thus the credential enables the employer to reliably distinguish low-ability workers from high-ability workers. The concept of signaling is also applicable in competitive altruistic interaction, where the capacity of the receiving party is limited.