[1] Although signalling theory was initially developed by Michael Spence based on observed knowledge gaps between organisations and prospective employees,[2] its intuitive nature led it to be adapted to many other domains, such as Human Resource Management, business, and financial markets.
Education credentials can be used as a signal to the firm, indicating a certain level of ability that the individual may possess; thereby narrowing the informational gap.
Michael Spence considers hiring as a type of investment under uncertainty[2] analogous to buying a lottery ticket and refers to the attributes of an applicant which are observable to the employer as indices.
The employer is supposed to have conditional probability assessments of productive capacity, based on previous experience of the market, for each combination of indices and signals.
But good employees know that they deserve to be paid more for their higher productivity, so they desire to invest in the signal—in this case, some amount of education.
Of key importance to the value of the signal is the differing cost structure between "good" and "bad" workers.
In general, the degree to which a signal is thought to be correlated to unknown or unobservable attributes is directly related to its value.
If the appropriate cost/benefit structure exists (or is created), "good" employees will buy more education in order to signal their higher productivity.
It is also important that one does not equate the fact that higher wages are paid to more educated individuals entirely to signalling or the 'sheepskin' effects.
Empirical studies of signalling indicate it as a statistically significant determinant of wages, however, it is one of a host of other attributes—age, sex, and geography are examples of other important factors.
To illustrate his argument, Spence imagines, for simplicity, two productively distinct groups in a population facing one employer.
Their offered wage schedule W(y) will be: Working with these hypotheses Spence shows that: In conclusion, even if education has no real contribution to the marginal product of the worker, the combination of the beliefs of the employer and the presence of signalling transforms the education level y* in a prerequisite for the higher paying job.
In equilibrium, the cost of obtaining the credential must be lower for high productivity workers and act as a signal to the employer such that they will pay a higher wage.
[6] Signaling typically occurs in an IPO, where a company issues out shares to the public market to raise equity capital.
To overcome this information asymmetry, firms may use signaling to communicate their true value to potential investors.
Various forms of signaling have also been observed during IPOs, especially when companies underprice the offered share price to prospective investors.
This represents a substantial indirect cost to the issuing firm, but allows initial investors to achieve sizeable financial returns at the very first day of trading.
A reputable underwriter, such as a well-known investment bank, can signal that the issuing firm is of high quality and has a strong likelihood of future success.
Information asymmetry can make it difficult for investors to distinguish between true signals of quality and mere attempts to manipulate the market.
Moreover, the use of signals can lead to a "winner's curse" where investors overpay for shares that are not worth the price paid.
[9] Thus, understanding the costs and benefits of different signaling mechanisms is crucial in improving market efficiency and reducing information asymmetry problems.
[20] In respect to donations to a national park, researchers found participants were 25% less generous when their identities were not revealed relative to when they were.
Dimoka et al. (2012)[27] analyzed data from eBay Motors on the role of signals to mitigate product uncertainty.
In internet-based hospitality exchange networks such as BeWelcome and Warm Showers, hosts do not expect to receive payments from travelers.
Both networks as non-profit organizations grant trustworthy teams of scientists access to their anonymized data for publication of insights to the benefit of humanity.
[29] In a study published in the Journal of Economic Theory, a signalling model has been proposed that has a unique equilibrium outcome.
[30] In the principal-agent model it is argued that an agent will choose a large (observable) investment level when he has a strong outside option.
Due to the nature of international relations and foreign policy, signaling has long been a topic of interest when analyzing the actions of the agents involved.
Recent studies such as the Journal of Conflict Resolution suggest that sinking costs and tying hands are both effective in increasing credibility.
Later in works by Slantchev (2005), it was suggested that due to the nature of using military mobilization as a signal, despite having intentions to avoid war can increase tensions and thus both be a sunk cost and can tie the party’s hands.