S is for signalling

From the NZ Initiative:

If you have ever bought a used car, you will be familiar with this problem. The seller, of course, knows whether the car is reliable, he may know the previous owners, and he would also be aware of any hidden flaws.

For you as the buyer, the situation is a bit more complicated. At first sight, a gem is difficult to differentiate from a lemon. With a bit of polish and some new car scent spray, you can put a nice gloss even on a dud.

In such situations, which economists describe as ‘asymmetric information’, markets do not work well. Buyers, not knowing whether they will get good or bad quality, have a reduced willingness to pay. But for the price buyers are prepared to pay, the owners of good quality cars would not be willing to sell them. As a result, we end up with a market where poor quality cars trade at low prices.

This is the dilemma described in George Akerlof’s classic paper ‘The Market for Lemons’, and it is here where ‘signalling’ comes into play. In order to overcome the problem of asymmetric information, the sellers of higher quality goods, whose quality is difficult to ascertain prior to use, need to find ways of showing their quality.

In the case of used car markets, a credible signal for the quality of the car would be a warranty. If the buyer is confident that the car is not a lemon, he could promise to cover all repairs for the next couple of years. In doing so, he could justify charging a higher price.

Such quality signals are far more widespread than you may first think. Advertising is the most obvious example.

If you have ever wondered why companies hire celebrities to endorse their products, think about it this way: The reason why actress Andie MacDowell promoted L’Oreal was not because it had stopped her from ageing but because she was worth it. Paying her handsomely signalled that L’Oreal was serious about the quality of their products. For the same signal, the company could have also publicly burned $100 notes as well (but it would not have looked so good).

Academic titles fall in the same category. Some of us get them because we are interested in learning and knowledge. The real value of a PhD lies elsewhere, however. It signals that you are capable of achieving things that require a sustained effort. That’s why people get PhDs – and that’s why companies hire PhDs.

Doctorates, warranties and Andie MacDowell may differ in many ways. One thing they have in common: They are strong signals.

Next week is T for Tax.