In contract theory, signalling (or signaling; see spelling differences) is the idea that one party (the agent) credibly conveys some information about itself to another party (the principal).
Although signalling theory was initially developed by Michael Spence based on observed knowledge gaps between organisations and prospective employees, its intuitive nature led it to be adapted to many other domains, such as Human Resource Management, business, and financial markets.
In Spence's job-market signaling model, (potential) employees send a signal about their ability level to the employer by acquiring education credentials. The informational value of the credential comes from the fact that the employer believes the credential is positively correlated with having the greater ability and difficulty for low-ability employees to obtain. Thus the credential enables the employer to reliably distinguish low-ability workers from high-ability workers. The concept of signaling is also applicable in competitive altruistic interaction, where the capacity of the receiving party is limited.
Introductory questions
Signalling started with the idea of asymmetric information (a deviation from perfect information), which relates to the fact that, in some economic transactions, inequalities exist in the normal market for the exchange of goods and services. In his seminal 1973 article, Michael Spence proposed that two parties could get around the problem of asymmetric information by having one party send a signal that would reveal some piece of relevant information to the other party. That party would then interpret the signal and adjust their purchasing behaviour accordingly—usually by offering a higher price than if they had not received the signal. There are, of course, many problems that these parties would immediately run into. Effort: How much time, energy, or money should the sender (agent) spend on sending the signal? Reliability: How can the receiver (the principal, who is usually the buyer in the transaction) trust the signal to be an honest declaration of information? Stability: Assuming there is a signalling equilibrium under which the sender signals honestly and the receiver trusts that information, under what circumstances will that equilibrium break down?
Job-market signalling
In the job market, potential employees seek to sell their services to employers for some wage, or price. Generally, employers are willing to pay higher wages to employ better workers. While the individual may know their own level of ability, the hiring firm is not (usually) able to observe such an intangible trait—thus there is an asymmetry of information between the two parties. 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. This is beneficial to both parties as long as the signal indicates a desirable attribute—a signal such as a criminal record may not be so desirable. Furthermore, signaling can sometimes be detrimental in the educational scenario, when heuristics of education get overvalued such as an academic degree, that is, despite having equivalent amounts of instruction, parties that own a degree get better outcomes—the sheepskin effect.