A signal is an action that reveals information. Let’s look at higher education, for example. A large fraction of the value you receive from your degree comes on the

A signal is an action that reveals information. Let’s look at higher education, for example. A large fraction of the value you receive from your degree comes on the day you earn your diploma. Your expected wages don’t increase with each class you complete along the way; instead, they spike sharply at the end when you receive your diploma. This is often referred to as the “Sheepskin Effect” because diplomas used to be printed on sheepskin.

Nobel Prize winner Michael Spence did research on this subject and found that education is valuable not necessarily because it creates valuable skills, but rather that it signals valuable skills. So how does the signal, represented by a degree, alleviate asymmetric information?

Employers don’t necessarily know how smart or skilled you are. Your degree, however, provides a credible signal of these traits and gives them more information they can use in the hiring process.

What other signals exist? We discuss examples like diamond engagement rings, why criminals tattoo their face, and why a peacock has a colorful tail. Let us know what examples you come up with in the comments.

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So how did the Korean Hyundai become such an excellent car, and earn so much success in the marketplace? Well, let's go back in time. In 1986, the first Hyundai Excel was sold in the United States. It was not entirely attractive, but it was inexpensive. The problem though that it just didn't work that well. So Hyundais quickly developed a reputation for being lower quality cars and in time, they became the butt of jokes among American consumers.


Jay Leno, who was at the time was host of the Tonight Show, said that you could double the value of your Hyundai by filling it up with gas. Hyundai wanted to flip this reputation and compete with the more successful companies, such as Honda and Toyota, and they managed. Hyundai decided they would invest in new advanced factories, in worker training, and in quality control. This in turn would result in much higher quality cars. But how could Hyundai convince consumers of this higher quality - quality that was maybe difficult to see unless you had owned the car for a few years already. Consumers didn't, in fact, usually know what was going on in Hyundai’s factories.


So again, we have a case of asymmetric information where Hyundai knew much more about the quality of its products than did consumers. So, what could the company do? Hyundai rolled out what it called “America's Best Warranty.” The warranty assured consumers that the cars were high quality and it got consumers to start buying those cars. What's great about this idea is that it doesn't actually cost Hyundai very much because the cars were in fact high quality and they didn't need to be fixed all the time. This Hyundai warranty is an example of a signal.


A signal is an expensive action that reveals information, and for it to work a signal has to be credible. In this case, if Hyundai cars were still unreliable, such a comprehensive warranty would have been extremely costly to Hyundai. Consumers, Therefore, bought Hyundai figuring that if the warranty were so strong, well, the company had to have a lot of faith in its cars.


So how does a signal help alleviate asymmetric information? Hyundai knew their cars were of high quality but consumers didn't know. The warranty was a credible signal that conveyed information to the consumers, specifically information about the quality under the hood, that consumers otherwise couldn't easily judge. This signal gave consumer the information necessary to have enough confidence to buy a Hyundai. Indeed, this story had a happy ending.


So, where else might we see signaling? Well, let's consider a puzzle in higher education. If going to college was simply all about learning skills, then you would expect your expected wages would steadily grow as you completed more and more classes. For instance, when you would get halfway through with your degree, you would get half of the expected wage increase from earning the degree. In each class you're learning valuable skills so your expected wages should incrementally rise with each class completed, right? Well, wrong.


In fact, a large fraction of the value of a degree comes on the day you earned your degree and finish. So rather than seeing a steady increase in your expected wage as you go through college, you have a sharp upturn in that wage right at the end. Again, when you finish. This is called the “Sheepskin Effect” because diplomas used to be printed on sheepskin. Additionally, we see people who receive a degree in, say, Art History, and they take jobs that maybe have little or nothing to do with history of art. Yet these people receive higher wages than those without a degree altogether.


Why? Well, the learning of art history may not be applicable to the jobs, but it shows those people have some kind of talent. The signaling theory of education from Nobel Prize winner Michael Spence is that education is valuable, not only because it teaches us things, but also because it signals worker quality. There’s asymmetric information between an employee and a potential employer. The employer doesn't know how smart, determined, or conscientious you might be. A degree provides a credible signal of these traits and gives employers more information about possible hires.


Why is it credible? Well, getting a degree is harder for someone who isn't as smart, determined, or conscientious. Here are some other signals to think about. Are diamond just about giving your love one something beautiful? Or is it also important the ring costs a lot? What asymmetric information might this signal help reveal? Here's another one. Why do criminal tattoo their faces? What might be the asymmetric information problems they're trying to solve? And signaling is not only a human phenomenon. Why does a peacock drag around a large colorful tail which might appear to hinder its survival? What kind of signal might be going on there? And to whom?


Check your intuitions to these puzzles in our practice questions after this video. So, now that we've covered how signals can help overcome asymmetric information, you might wonder, "Are signals always a good thing?” It might seem wasteful to spend four years at college, or to spend two months’ salary on the ring just to signal something. Students might prefer to learn more rather than spending so much time jumping through hoops, and it might be better to buy something more practical for a potential spouse than just a ring.


While signals do create some inefficiency, they also generate benefits by creating more information. They help individuals in markets realize gains from trades by overcoming problems of asymmetric information. So, if you've enjoyed this video, well, give us a signal and please let us know. Drop us a note or leave a suggestion for us. Your feedback will help determine how we produce future videos and materials. Thanks.

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