Signals Are All Around You

“Effective signals in a marketplace have the characteristic that the people with a high quality product have lower costs of emitting the signal than people with a low quality product, explains Nobel Laureate economist Michael Spence. “So when the equilibrium sets up in the marketplace, the high quality people will send the signal that they’re high quality and the low quality ones won’t do it.”

Spence’s classic example is how qualified workers can signal their worth in the job market. The basic premise is that there is an information asymmetry during hiring—employers can’t sufficiently determine a worker’s productivity by the interview alone. But by going to college, a worker can signal his productivity to employers. Only someone with a high quality product (his own intelligence and productivity) would subject himself to the rigors of college; if he has a low quality product, the relative cost (money and effort) would be too high to justify enrolling in college. Thus, the education is less important for what particular knowledge that worker might have learned and more important as a signal of his inherent worth.

Consider economist George Akerloff’s example of a scenario in which no signaling occurs: “If you can’t distinguish between two cars of differing quality on the buying side, they all get lumped together and they’re viewed as a lottery,” says Spence. “In the used car market, if there are no credible signals when you buy a car, some of them will be well-looked after, some of them will be lemons, and a lot of stuff in between, you’re just buying a lottery; you don’t really have a cost-effective way of knowing.” In this market, the average price of all of the cars would naturally arrive at an equilibrium point well below the value of the good cars. And as a result, the owners of the good cars would choose not the sell their cars in this market, thereby driving all quality out of this market. All that would remain are the lemons. 

The same thing occurs in the pharmaceutical industry argues Donald Light, a professor of comparative health policy at the University of Medicine and Dentistry of New Jersey. Leaving drug testing in the hands of pharmaceutical companies, providing firewalls of legal protection behind which information about harms or effectiveness can be hidden, and allowing a low bar ofefficacy in order for a new drug to be approved all contribute to making this a market for lemons, says Light. His recent study estimates that 85 percent of all new drugs have little or no benefit, while potentially causing adverse side effects. But because Big Pharma possesses all the information in this market, it can get away with duping the public, he argues. 

More Resources: 

—Michael Spence’s Nobel Prize lecture on signaling