The Hindu Business Line : Signalling Theory and market efficiency

LAST week, we discussed bounded rationality, which exists because we have limited information and time for decision-making. But what happens if more information is available?

Dr Michael Spence, a Nobel Prize - winning economist, conducted research in this area. His work culminated with the Signalling Theory, which states that the markets will be more efficient if sellers provide more information to the buyers.

Take the case of the second-hand car you wanted to buy last week. You walked out of the dealer's shop because you did not know whether the car was of poor quality.

Now, suppose the dealer threw in a two-year warranty, and one-year free maintenance. Would that change your decision to buy the car for Rs 1 lakh? It could.

The reason? The seller by providing a warranty and free maintenance is conveying the information that the car is of good quality.

What is the implication? The second-hand car dealer can now expect to sell the car for Rs 1 lakh. In the earlier instance, the dealer would have had to settle for, say, Rs 0.75 lakh, as most buyers would have walked away thinking that the car is a lemon.

Dr Spence developed the Signalling Theory by applying it to the labour market. Specifically, his theory developed on the problems that employer's face in the recruitment process, given that they have no prior information about people's skill-sets.

His theory states that high productivity people will seek more education than low-productivity people. This will prompt employers to take higher education as a signal, and offer higher salaries to such employees.

This theory can be applied in the financial markets too; a company increasing its dividends is signalling that its prospects are better. In short, signals help in better market efficiency.

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