Module 11.4 Signaling Lecture

Asymmetric Information

• Occurs when one party has more or better information than the other, leading to potential market failures.

• Example: A car dealer knows more about the quality of a car than the customer.

Cheap Talk

• Refers to uninformed or untrustworthy claims made by parties.

• For instance, car dealers claiming their vehicles are excellent without any evidence.

• Since making such claims incurs no cost, they are not credible.

Signaling

• The action taken by the informed party to prove the quality of their product or service.

• Requires a costly action to be convincing, such as offering warranties or guarantees:

• Warranties:

  • A generous warranty indicates confidence in the product's quality.

  • If products are poorly made, the cost of providing warranties would outweigh benefits.

  • High-quality car manufacturers can afford longer warranties because their products are less likely to fail.

Examples of Signaling in Nature

• Peacock Tails:

• Tails serve no immediate benefit and increase predation risk but signal to potential mates of male fitness.

• A large, vibrant tail indicates good genes and resources, making the male more attractive to females.

Signaling in Human Behavior

• Can also be observed in the dating market:

• Men may drive flashy cars as a signal to attract mates, suggesting wealth or good genes.

• Like peacock tails, this type of signaling has a cost associated with it to prove its legitimacy.

Conclusion

• Effective signaling must involve a cost, whether in money, time, or effort, to be credible and meaningful.

• In both the marketplace and personal relationships, discerning between cheap talk and true signals is crucial.