Signalling and screening are two distinct strategies for resolving information asymmetry, differing primarily in which party takes action. In signalling, the informed party (e.g., a job applicant) takes a costly action to reveal their private information. In screening, the uninformed party (e.g., an employer) designs a mechanism or menu of choices (e.g., different contract types) to induce the informed party to reveal their private information through self-selection. Signalling is initiated by the party with private information, while screening is initiated by the party without it.

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In economics, signalling is a strategy where an informed party takes a costly action to credibly convey private information to an uninformed party. For a signal to be effective, the cost of sending it must be lower for high-quality or high-ability agents than for low-quality ones. This cost differential allows the uninformed party to distinguish between types, helping to overcome problems like adverse selection. Common examples include educational credentials in the labor market or warranties for products.

Signalling (Economics)

In economics, screening is a strategy employed by an uninformed party to induce an informed party to reveal their private information, helping to mitigate problems like adverse selection. The uninformed party designs a mechanism, such as a menu of contract choices (e.g., insurance policies with different deductibles), that causes different 'types' of informed parties to self-select and reveal their hidden attributes.

Screening (Economics)

A product warranty can act as a credible signal of high quality from a seller to a buyer. The reasoning is that offering a warranty is more costly for a seller of a low-quality product, which is more likely to break and require service. Therefore, only high-quality sellers can afford to offer extensive warranties, allowing consumers to infer product quality and mitigating adverse selection in markets for goods like used cars.

Product Warranties as a Signal of Quality

Developed by Michael Spence, this economic model was the first to formalize the idea of signalling. It demonstrates how, in a job market with asymmetric information about worker productivity, individuals can use education as a signal. The model shows that for the signal to be effective, the cost of acquiring education must be negatively correlated with productivity. This allows employers to offer higher wages to more educated workers, leading to a separating equilibrium.

Spence's Job Market Signalling Model

A separating equilibrium is an outcome in a signalling game where agents of different 'types' (e.g., high-productivity vs. low-productivity workers) choose different signals. This allows the uninformed party (e.g., an employer) to perfectly infer the agent's type based on the signal observed. This outcome is possible when the costs and benefits of signalling are such that it is only worthwhile for the 'high-quality' type to send the signal.

Separating Equilibrium in Signalling Games

A pooling equilibrium is an outcome in a signalling game where agents of all 'types' (e.g., both high- and low-productivity workers) choose the same signal. Consequently, the uninformed party cannot distinguish between the types based on the signal and must rely on prior beliefs. This occurs when the costs of signalling are such that it is either beneficial for all types to send the signal or for none to do so, meaning the signal fails to convey private information.

Pooling Equilibrium in Signalling Games

Signalling vs. Screening

A costly signal is an action taken by an informed party that is intentionally expensive to perform. For the signal to be effective in conveying private information, the cost of sending it must be differentially high for different 'types' of senders. Specifically, it must be prohibitively expensive for a low-quality type to mimic the signal of a high-quality type, thus ensuring the signal's honesty.

Costly Signal

A credible signal is a piece of information conveyed by an informed party that an uninformed party can believe to be true. In signalling theory, credibility is achieved when the signal is structured in such a way that it is not in the best interest of a low-quality or dishonest sender to produce it. This is typically achieved through a cost mechanism, where the cost of falsely signalling is greater than the potential benefit.

Credible Signal

In the labor market, a job applicant's education level can serve as a signal to a potential employer about their underlying abilities, such as productivity or diligence. This signal is considered credible because acquiring a higher level of education is costly in terms of time, effort, and money. The theory posits that these costs are lower for high-ability individuals than for low-ability individuals, allowing employers to use educational attainment to differentiate between applicant types and mitigate the problem of adverse selection.

Education as a Signal in the Labor Market

Insurance companies can use deductibles as a screening device to sort customers by their risk level. By offering a menu of policies—for example, one with a high deductible and low premium, and another with a low deductible and high premium—the insurer induces customers to reveal their private information. Cautious, low-risk individuals are more likely to choose the high-deductible plan to save on premiums, while higher-risk individuals are more willing to pay the higher premium for better coverage. This self-selection helps the insurer mitigate the problem of adverse selection.

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