It can be argued that without signaling, Akerlof’s Market for Lemons would vanish, or at least all innovation and delta quality would be driven out. Akerlof, economics Nobel laureate in 2001, described how:

the interaction between quality heterogeneity and asymmetric information can lead to the disappearance of a market where guarantees are indefinite. In this model, as quality is undistinguishable beforehand by the buyer (due to the asymmetry of information), incentives exist for the seller to pass off low-quality goods as higher-quality ones. The buyer, however, takes this incentive into consideration, and takes the quality of the goods to be uncertain. Only the average quality of the goods will be considered, which in turn will have the side effect that goods that are above average in terms of quality will be driven out of the market. This mechanism is repeated until a no-trade equilibrium is reached.

Why is it that there is a market for lemons, like in used cars, when there are reasons why there shouldn’t? Signaling provides some light to the theory.

In Spence’s winning paper Signaling in Retrospect and the Informational Structure of Markets, education is seen as a signal in the labor market. From his Prize lecture:

The idea behind the job market signaling model is that is there are attributes of potential employees that the employer cannot observe and that affect the individual’s subsequent productivity and hence value to the employer on the job.

He then introduces the basis for the mathematical model subsequently built:

Let us suppose that there are just two groups of people. Group 1 has productivity or value to any employer of 1, and Group 2 has productivity of 2. In this example, these productivity values do not depend on the level of investment in the signal. If there were no way to distinguish between people in these two groups then if both groups stay in the market, the average wage would be 2 – α, where α is the fraction of the population in group 1, and everyone would get that wage. If the higher productivity group through dissatisfaction or for any other reason, exits this labor market, the average productivity and the wage drop to 1. This phenomenon when it occurs is sometimes called the adverse selection problem, a label most commonly applied to insurance markets. It is structurally the same problem that Akerlof described in his famous paper on used cars (lemons).

Why is Education an Honest Signal in this famous Nobel winning paper?

Quite simply, because it is expensive and as such not easily falsifiable.

The job-market model is a way of looking at product pricing and markets. The analogy is clear: Job seekers = Complex product offering, Skill level = Product Utility, and Wages = Price, but Education = What?

Education = Marketing!

What is the purpose and value of Marketing? Marketing is sometimes treated as a necessary evil, something we would all rather not have to truck with and most certainly not something that adds “real” value to the product. Wrong! The value of Marketing seen as attempts of Honest Signaling is huge:

• Branding. Branding is a form of honest signaling. It is a promise that is hard to break. IBM cannot afford to put its name on a dysfunctional product, as this hurts it. You can therefore trust software IBM-branded software.
• Advertising. Advertising has lost most of its credibility, and has equally lost in persuasiveness. Despite this, it can be seen as a mechanism where the signal itself is the value, not the content. The “It must be good since they can afford to blow so much money on advertising this stuff” concept, first introduced by Nelson (1974) who described the idea of advertising signaling quality by dissipating part of the profits, then formalized by Kihlstrom and Riordan (1984), and Milgrom and Roberts (1986). Advertising is a form of honest signaling.
• Analysts. The industry of third party analysts, man in the middle, and honest brokers à la Gartner. More on this later.
• Without signaling, there would be no point in developing better products, as they would not command higher prices. The only rational decision would be to cost reduce.

Marketing -now defined as the signaling body- has developed new signals over time: adverts, public relations, and now social media. All of these are tactics of influence, but more usefully and insightfully defined as attempts at Honest Signaling. This creates a new framework from which we can find better ways to send Honest Signals to the market, and thereby capture this huge value.

Spence’s Job-market model provides an example for opaque products, and how they require a signaling mechanism to provide information. Opaque products require honest signaling, and so need to be marketed with that in mind. This means using analysts, branding, etc. is not a waste of resources. It makes rational sense for players to hire an honest signaler.

So, what is the value of Honest Signaling?

Honest Signaling allows the marketer to provide information on a product’s quality in a trustable manner, where it would otherwise be costly or difficult to do.

For example, how do you demonstrate that your data integration software is good?

• You cannot educate the market. Evaluating such products takes weeks, if not months. Customers do not have time to do thorough research on competing products.
• You cannot advertise. As mentionned before, advertising in its traditional form has lost its credibility, and therefore would not provide significant advantage.

So what options do you have?

• You can put a big brand name on it. A corollary to this is that it can make sense for a large company to purchase a small one in order to re-brand its product. In this specific case, the purchase might in itself be a sufficient Honest Signal, as it would not purchase it if it weren’t good.
• You can hire an analyst firm. The analyst firm then evaluates your product, and you can purchase the evaluation for display. If your software were poor, you couldn’t afford to do so as you would get a negative and detrimental evaluation. And so this is an Honest Signal.
• You can expose yourself to risk. Best example of this is a guarantee. Make an expensive promise and uphold it. If your software were poor, this would be prohibitively costly.
• You can fill the airwaves with advertising. Show that you can afford to squander resources. The key is not content, but volume.