My previous post was about complete and incomplete information and about revealing your advantages to your opponents to gain an even bigger advantage. I finished with a short discussion on signaling: How to credibly differentiate yourself from others to gain a higher payoff?
In his course on game theory, Ben Polak represents a good example on signaling by using a simplified model of the job markets. Here I represent it, with possibly different figures, but the idea holds:
- There are two types of workers only: good and bad
- 10% of all workers are good, 90% are bad
- a good worker produces 50 dollars worth of goods per day a bad worker produces only 20 dollars worth of goods
- employers cannot tell the difference between a good and a bad worker before hiring them
- the two types of workers are otherwise identical, just their output is different
- this game lasts only one day, to keep the calculations simple
On average, an employee produces 23 dollars worth of goods, so the average salary level is also 23 dollars. Therefore, the bad workers earn slightly more than they produce, and the good workers a lot less than they produce: a good employee would earn 50 dollars if he could signal credibly to the employer that he is a good worker. Of course, a bad worker would also want to earn 50 dollars instead of 20 or 23. Thus we need something to differentiate between the two, we need a signal.
A signal that differentiates the good workers from bad workers, or any types from one another in general, has to be such that good workers will always give the signal and bad workers will never give the signal. For a signal to be credible, it’s costs obviously have to be such, that they reduce enough the net salary of a bad worker, but do not reduce too much the net salary of a good worker: this way the bad workers will not be willing to give the signal while the good workers will always give the signal.
As an example of a signal, Mr. Polak mentions the possibility of dancing on the table in a job interview and singing a song about how good an employee you would be. Such a signal is obviously costly, being humiliating at the very least, but it does not help differentiate the two types of workers. After all, it is equally humiliating for both types, so even if a good worker would have the incentive to give the signal, the bad worker would have the same incentive, in order to be identified as a good worker and thus receiving the salary of 50 dollars. Clearly not all costly signals can separate the worker types from one another.
Education as a signal
It turns out that education is a form of signaling and conversely, among other things education has a role as a signal giver at the job market. Let’s introduce a two-year MBA that either type of worker can take. The costs of tuition are the same for both and so are those for housing, transport and food. We might argue that the two types have different opportunity costs in taking an MBA instead of working, but both types would earn 23 dollars since we do not yet have a signal to separate them at the job market. So why does the good worker do the MBA and the bad worker doesn’t, as I am proposing? The difference in the costs is the effort, the mental work, hours of sitting in lectures doing homework and assignments. For the bad worker the required effort to finish the MBA degree is much higher than for the good worker. So much, that receiving an MBA would reduce his net salary below current levels, even below 20 dollars.
Of course, in this example the figures can be forced to be in such a relation to one other that the signaling works. E.g. if we make the total costs of an MBA, including the effort, to be 10 dollars per year for the good worker and 20 dollars per year for the bad worker, it is obvious that the good worker will do the MBA and receive a net salary of 30 dollars after being identified as a good worker and hired by an employer. Conversely, the bad worker will not take the MBA, since his net salary for doing an MBA and being identified as a good worker is 10 dollars, which is below the 20 dollars he would receive otherwise. In addition, the employers have to believe that good workers, and good workers only, take an MBA. Otherwise the good workers might, regardless of their MBA, be identified as bad workers reducing their incentive to take an MBA.
Even if the figures in the above example are arbitrary, the main point is that the signaling mechanism has to be such that it will provide reliable signals and no type has the incentive to deviate. Thus, when creating the mechanism, the related figures actually have to be chosen in such a way that the signaling is reliable and adjusts the payoffs properly. In our MBA example a one-year MBA would not suffice, since a bad worker would do the MBA and receive a net salary of 30 dollars, instead of the 20 dollars he would receive otherwise. On the other hand, a one-year MBA could be made a lot harder and work-intensive, so that the per-year costs are increased and, again, only the good workers go for the education.
Signaling in other areas of life and work
Signaling is not only useful and used in employee-employer relationships. For example, buyer-seller interactions might also require, or at least benefit from, signaling.
For example in the case of used cars information imbalance between the buyer and the seller can lead to all goods in the market being of poor quality. In such a case, the potential sellers of higher quality products would have to be able to reliably signal this quality to the potential buyers. The buyers do not have to signal their preferences, since a buyer looking for higher quality products will buy one, if he gets more value from it, and nobody will pay for a good more than the value received from buying and possessing the good. Thus, we do not have the potential problem of customers looking for low quality products suddenly hoarding all the high quality products.
Another interesting realm where signaling can be applied is the one of procurement. At least larger companies often have a centralized procurement function that is responsible for managing the main suppliers, conducting supplier selection and awarding contracts. When looking for a supplier, the procurement function has to create competition between the candidates to find out the best one for the given quality and specifications. However, a potential supplier must invest resources in the bidding process without any certain revenue or supply contract. If the potential supplier thinks that the expected payoff from the contract is low, he will not put too much effort in to the bidding. This might lead to the customer company receiving only a few offers or the offers being of poor quality and difficult to compare against one another. To increase the number and quality of the offers, the customer company would have to signal, in a reliable way, that the potential contract has a guaranteed, maybe even high value. The way to do this is to commit, before the bidding starts, to awarding the contract to one bidder and to one bidder only, and beforehand abstaining from any cherry picking between offers. This of course requires that a large enough pool of bidders is invited and that the background research on them has been done, since procurement will have to commit to one of the invited bidders. Therefore, their capabilities have to match the requirements well enough, so that in principle any solution could be accepted.
As we see, tying your hands or incurring costs to show your commitment and capability are some ways to reliably signal who you are. Consequently signaling can help you leverage those advantages that might otherwise go unnoticed. Information is power, and shared information can be overpower.