Prof. Bryan Caplan

Econ 370


Week 10:  Signaling

I.                     Some Puzzles

A.                 Why does non-job-related schooling still raise your income?  ("What does  this have to do with real life?")

B.                 Why won't people buy goods without a warrantee?

C.                Why do you use nice paper on a job application?

D.                Why do you (sometimes) have to wear a suit to work?

E.                 Why are wedding rings so expensive?

F.                 Why do countries have tons of weapons they never intend to use?

G.                Why do male peacocks have such huge tails?

II.                   The Resolution: Signaling

A.                 There are different "types" of people and firms: able and unable, smart and dumb, honest and dishonest, hard-working and lazy...

B.                 It is difficult to observe "types" directly.  (Captain Kirk on Star Trek: "Can you tell the good and bad people among you from their faces?")

C.                However: different types (may) have different costs (lower disutility) of performing the same observable activity.

1.                  Smart and hard-working people find it easier to do schoolwork.

2.                  Lazy people find it more costly to take extra effort with an application.

3.                  Honest firms find it cheap to provide warrantees.

D.                Therefore: It may be in the interest of the type in higher demand to go to school, fill out an application with extra care, provide a warrantee, etc. - even if the effort itself does NOTHING for buyer or seller!  People only want what the effort proves you already had in the first place.

E.                 Remember the distinction between bidding for a monopoly and lobbying for it?

F.                 A similar distinction holds for signaling.  Some signaling is basically just a cash transfer.  Other signaling is more like lobbying.

III.                  Signaling as a Transfer: Warrantees

A.                 One cheap and effective means of signaling is to provide warrantees ("money-back guarantees") on your products.

B.                 If you are honest and provide good products, it is cheap to do so.

C.                If you are dishonest and sell junk, it is very expensive to do so.

D.                Therefore: If you are honest, you can signal this fact by guaranteeing your products.  Customers see this and buy from you.  If you are dishonest, this would be prohibitively expensive, so dishonest suppliers don't even bother entering the market.

E.                 Is there a deadweight cost of warrantees?  Probably not much: if a customer exercises a money-back guarantee, there is simply a transfer from store to disgruntled customer.

IV.               Signaling as Lobbying: Education

A.                 Some kinds of education provide job skills; others don't seem to (engineering vs. philosophy).  But employers still pay more for more education.  Why?  Signaling.

B.                 Employers want people who are smart, hard-working and/or conform to "the rules." 

C.                People who are smart, hard-working and/or conform to "the rules"  find it easier/cheaper to get through school.  School doesn't improve them; rather, their ability to finish school shows they were good all along!

D.                Similarly, people who are dumb, lazy, and or non-conformist have trouble finishing school.  They find it too painful to finish, so they don't.

E.                 In sum: the class trouble-maker who complains that school has "nothing to do with real life" is often correct.  However, this does not mean that there is no economic return to attending school.

F.                 Does education signaling provide ANY social benefit?  Yes: It improves the match between jobs and people.

G.                But at the margin, educational signaling has negative externalities, and the deadweight costs you would expect.  Why?  The matching function of education could be served just as well if everyone signaled 50% less.

H.                 Intuitively: Assuming you learn nothing and don't like learning, then extra time and other resources spent are education are pure waste.

I.                     Questions:

1.                  Why not just give IQ tests?  (They are illegal, and don't screen out uncooperative smart people).

2.                  Why don't employees give employers a money-back guarantee if they turn out to be dumb, lazy, or non-conformist?  (This might be illegal; would it have other problems?)

V.                 Why Subsidize Signaling? (or, "Why Education Should be Taxed")

A.                 Question: If signaling has negative externalities, could government action make matters more efficient?

B.                 Answer: Yes - government could tax education.  Then everyone could get half as much education and still get the same job offers.

C.                In reality, of course, governments almost always massively subsidize education.  If the signaling theory is right, this makes no sense.

1.                  You now need a masters or Ph.D. for a job that used to require only an B.A.

2.                  You now need a B.A. for a job that used to require only high school.

D.                If education were unsubsidized, you might not be able to afford it; but then you probably wouldn't need it to get a good job either.  Firms would switch to apprenticing and other ways to find out your "type."

E.                 A lot of spending on education is not investment; it isn't even consumption.  It is pure waste.