What would you pay for prestige?

Why do so many people go on to university after finishing school? Why do some uni graduates get a job, but then go back to uni for further qualifications?

Why do sensible people dress up for a job interview – or wear a suit and tie if they're in court charged with an offence?

Joseph Stiglitz shared a Nobel Prize for work on information economics.
Joseph Stiglitz shared a Nobel Prize for work on information economics. 

For that matter, why do people engage in conspicuous consumption – buy flash clothes or cars or houses, or send their kids to flash private schools?

Why do so many businesses put so much money and effort into protecting and projecting their brands?

Everyone sends signals to convey their worth, even though they might not be entirely accurate. Illustration: Glen Le Lievre
Everyone sends signals to convey their worth, even though they might not be entirely accurate. Illustration: Glen Le Lievre 

Short answer to all those questions: because they're trying to signal something. What? Usually, their superior quality – although in the case of conspicuous consumption they're signalling their superior social status.

Signalling is simple

Signalling is something you don't read about in economics 101 textbooks, even though it occurs in all real-world markets.

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That's because the simple neo-classical model makes the unrealistic assumption of "perfect knowledge" – buyers and sellers know all they need to know about all goods and services – not just the range of prices on offer but also the characteristics of the goods offered by various sellers, including their quality.

For many years, progress in economic theory has involved relaxing the various assumptions of "perfect competition" to see what we can learn from more realistic assumptions – which, by the very nature of theory and models, will still be a fairly simplified version of reality. (If a model was as complex as the real world, it would tell us nothing about what causes what in that world.)

Since the early 1970s, economic theorists have been studying "imperfect knowledge" (which in econospeak means "far from perfect", not "almost perfect"), recognising that there's much relevant information people don't know and that information is often costly to collect (in money or time).

Sellers hold the cards

As well, information is often "asymmetric", in that the people selling something, usually being professionals, know a lot more about it than buyers, usually amateurs, do.

In 2001 three American academic economists – Michael Spence, George Akerlof and Joseph Stiglitz – shared the Nobel prize in economics for their seminal contributions to the relatively new field of "information economics".

Akerlof (who's married to a certain central bank chairwoman) got his gong for a paper he wrote in 1970 called The Market for Lemons, aka used cars. Spence got the gong for a paper he wrote in 1973 about signalling in the job market.

Why do people delay their income earning to get educational qualifications?

So let's start again: why do people delay their income earning to get educational qualifications?

If you say it's because they want to gain knowledge and expertise in some field to make their labour more valuable – to increase their "human capital" – and help them get a better-paid job, you're not wrong and Spence wouldn't disagree with you.

A degree of confidence

But he focuses on a different, less obvious motivation. Employers are looking for intelligent workers and are willing to pay more for their services. But when you're hiring workers, it's hard to know how smart they really are. As economists say, it's an "unobservable characteristic".

So how do workers who know they're smart demonstrate that to potential employers? By using their educational qualifications to signal the fact. Employers are impressed by qualifications because they know they're not easy to obtain – they're costly, in a sense.

Of course, people who aren't so smart can gain qualifications if they try hard enough. But genuinely smart people don't have to try as hard, so they can gain higher, better qualifications than the less-smart can, and employers know this.

You're in line for a Nobel prize when you open up a new field and then other, more junior academics come along behind you to elaborate and expand on your discovery, eventually making it look pretty primitive.

By now thousands of academic papers have been written about signalling in various markets. It's become part of the study of "industrial organisation" (industry economics, as we used to say) but is also a branch of game theory.

Theorists have looked at cases of people sending signals implying they possess qualities that they don't and cases where signals are distorted by "noise" (say, you struck it lucky in the exams). And whereas in simple theory markets only ever have one equilibrium point – where everything is in balance – with signalling there are multiple equilibria.

Growing up

One signalling theorist is Dr Sander Heinsalu, a bright young Estonian now in the Research School of Economics at the Australian National University.

In a recent paper he develops a "repeated noisy signalling model", quoting examples such as a politician giving speeches intended to make him appear competent, a firm buying positive product reviews, and a male deer growing antlers every mating season.

He finds that, if the cost and the benefit of signalling are constant across periods, the degree of signalling effort falls over time. This fits with the way conspicuous consumption falls with age.

In another paper Heinsalu says the conclusion of most signalling papers is that people for whom gaining more of the valued characteristic would be costly don't exert as much signalling effort as those for whom it is less costly.

But in his own paper he demonstrates that in some circumstances it can be the other way round.

With corruption, politicians face minor temptations and big ones. A pollie who is "too clean" may be avoiding minor misdeeds so he can survive long enough to engage in major graft when the opportunity arises, whereas another planning to avoid graft may not worry about small misdemeanours.

The guilty may deny accusations more strenuously than the innocent do because the innocent know they'll have less trouble proving it later.

As Shakespeare said, "the lady doth protest too much, methinks".

But if you want more proof than a quote from the bard, read the paper on his website. Hope your maths is up to it.

Twitter: @1RossGittins

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