S is for signalling

July 6th, 2014 at 2:00 pm by David Farrar

From the NZ Initiative:

If you have ever bought a used car, you will be familiar with this problem. The seller, of course, knows whether the car is reliable, he may know the previous owners, and he would also be aware of any hidden flaws.

For you as the buyer, the situation is a bit more complicated. At first sight, a gem is difficult to differentiate from a lemon. With a bit of polish and some new car scent spray, you can put a nice gloss even on a dud.

In such situations, which economists describe as ‘asymmetric information’, markets do not work well. Buyers, not knowing whether they will get good or bad quality, have a reduced willingness to pay. But for the price buyers are prepared to pay, the owners of good quality cars would not be willing to sell them. As a result, we end up with a market where poor quality cars trade at low prices.

This is the dilemma described in George Akerlof’s classic paper ‘The Market for Lemons’, and it is here where ‘signalling’ comes into play. In order to overcome the problem of asymmetric information, the sellers of higher quality goods, whose quality is difficult to ascertain prior to use, need to find ways of showing their quality.

In the case of used car markets, a credible signal for the quality of the car would be a warranty. If the buyer is confident that the car is not a lemon, he could promise to cover all repairs for the next couple of years. In doing so, he could justify charging a higher price.

Such quality signals are far more widespread than you may first think. Advertising is the most obvious example.

If you have ever wondered why companies hire celebrities to endorse their products, think about it this way: The reason why actress Andie MacDowell promoted L’Oreal was not because it had stopped her from ageing but because she was worth it. Paying her handsomely signalled that L’Oreal was serious about the quality of their products. For the same signal, the company could have also publicly burned $100 notes as well (but it would not have looked so good).

Academic titles fall in the same category. Some of us get them because we are interested in learning and knowledge. The real value of a PhD lies elsewhere, however. It signals that you are capable of achieving things that require a sustained effort. That’s why people get PhDs – and that’s why companies hire PhDs.

Doctorates, warranties and Andie MacDowell may differ in many ways. One thing they have in common: They are strong signals.

Next week is T for Tax.

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10 Responses to “S is for signalling”

  1. wikiriwhis business (4,002 comments) says:

    It stuns me that big companies still believe celebrity endorsements can persude a gullible public.

    The lowest common denominator still works.

    Human nature will never change, advance or enlighten.

    We are though being kept minamilised so crave looking successful as we can.

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  2. MH (757 comments) says:

    And yet we still trudge up to polling booths based on asymmetric information.

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  3. nasska (11,509 comments) says:

    ….”The real value of a PhD lies elsewhere, however. It signals that you are capable of achieving things that require a sustained effort.”…..

    Unless the doctorate is in one of the hard sciences it is more likely to signify that the holder preferred varsity life over the toil & tribulation of working in the real world.

    However, all is not lost…..a PHD in Maori Studies or Political Science can be framed & cover defects in wallpaper once hung.

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  4. Nuwanda (83 comments) says:

    “In such situations, which economists describe as ‘asymmetric information’, markets do not work well.”

    Rubbish. The market is working exactly as it should.

    That one party has more information than the other is a regular aspect of trade. As a buyer I may know that I can sell an item for a lot more than the seller is asking. So why doesn’t the seller just sell it for that price instead of allowing me to reap the profit? My info could be based on superior ability or just pure luck. That it’s asymmetric is good for me but not necessarily bad for him.

    This is often used in a risk sense with lending or insurance, but regardless, the “problem” of asymmetric information is built into the price. Care to define what the price SHOULD be?

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  5. wikiriwhis business (4,002 comments) says:

    MH

    This is why third party representation is growing and why the govt is so determined to bring back FPP to minimalise voter power.

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  6. Captain Pugwash (98 comments) says:

    Celebrity endorsement just fools the general population that a certain product is “Cool and desirable” not that it is actually a quality product.

    George Clooney advertises Nescafe, I doubt that any serious coffee drinker would consider Nescafe to be a quality coffee.

    Three finance companies who had “Celebrities” advertising for them.

    Hanover Finance – Richard Long
    Provincial Finance – Colin Meads
    Lombard – Various former Cabinet Ministers

    I don’t know who made money out of investments in these companies, but it certainly wasn’t the Investors (customers), you could argue that they were”legally” ripped off.

    BTW – A friend of SHMBO, who is a professional makeup artist considers L’Oreal over-priced crap.

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  7. Griff (7,713 comments) says:

    The whole consumerism thing passes me by.
    To me the more spent on advertising the less value I place in the product. It says to me the product is not competitive if you spend to much on advertising effort.

    The classic is the overpriced products on talk back radio.
    There was a campaign to sell fire extinguishers for one hundred dollars when you can buy a far bigger and more effective one from the local hardware store for twenty five bucks. Many products come under the same banner.

    I always read the lapel and buy on contents not brand. Weed killer glyphosate 360g/L is the same Monsanto’s roundup @ $60L or a unknown brand @ $10L Ditto for painkillers cleaners and similar commodity type products.

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  8. nasska (11,509 comments) says:

    Totally agree Griff. In fact celebrity endorsement is more likely to turn me away from a product.

    I tend to reason that if the crap needed an autocue reader to promote it then it is probably junk designed for the feeble minded & gullible who would have time or inclination to pay heed to the advertisement.

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  9. peterwn (3,272 comments) says:

    In the days of small fragmented hospital boards, some board members were so ignorant of doctors’ qualifications, that some considered that the applicant with the most letters after his name was the best applicant for the job! Some applicants were so concerned with this that they would subtlety contact board members about the value of their qualifications despite the risk of having their applications disqualified. Conversely the ‘message’ here was to collect as many ‘qualifications’ and institution memberships as possible even though they should theoretically carry little weight.

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  10. prosper (166 comments) says:

    I don’t who wrote the article or if he has a degree but he has displayed a lack of knowledge that is staggering and an arrogance that is incredible. I think he should by a small dairy and get an education in business and marketing.

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