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In economics, more precisely in contract theory, signalling (or signaling: see American and British English differences) is the idea that one party (termed the agent) credibly conveys some information about itself to another party (the principal). For example, in Michael Spence's job-market signalling model, (potential) employees send a signal about their ability level to the employer by acquiring certain education credentials. The informational value of the credential comes from the fact that the employer assumes it is positively correlated with having greater ability.
Introductory questions 
Signalling took root in the idea of asymmetric information (a deviation from perfect information), which says that in some economic transactions, inequalities in access to information upset the normal market for the exchange of goods and services. In his seminal 1973 article, Michael Spence proposed that two parties could get around the problem of asymmetric information by having one party send a signal that would reveal some piece of relevant information to the other party. That party would then interpret the signal and adjust her purchasing behaviour accordingly — usually by offering a higher price than if she had not received the signal.
There are, of course, many problems that these parties would immediately run into.
- How much time, energy, or money should the sender (agent) spend on sending the signal?
- How can the receiver (the principal, who is usually the buyer in the transaction) trust the signal to be an honest declaration of information?
- Assuming there is a signalling equilibrium under which the sender signals honestly and the receiver trusts that information, under what circumstances will that equilibrium break down?
A basic job-market signalling model 
In the job market, potential employees seek to sell their services to employers for some wage, or price. Generally, employers are willing to pay higher wages to employ better workers. While the individual may know his or her own level of ability, the hiring firm is not (usually) able to observe such an intangible trait — thus there is an asymmetry of information between the two parties. Education credentials can be used as a signal to the firm, indicating a certain level of ability that the individual may possess; thereby narrowing the informational gap. This is beneficial to both parties as long as the signal indicates a desirable attribute — a signal such as a criminal record may not be so desirable.
Assumptions and groundwork 
Spence began his 1973 model with a hypothetical example. Suppose that there are two types of employees — good and bad — and that employers are willing to pay a higher wage to the good type than the bad type. Spence assumes that for employers, there's no real way to tell in advance which employees will be of the good or bad type. Bad employees aren't upset about this, because they get a free ride from the hard work of the good employees. But good employees know that they deserve to be paid more for their higher productivity, so they desire to invest in the signal — in this case, some amount of education. Spence assumes that education does not increase the productivity of an individual. But he does make one key assumption: good-type employees pay less for one unit of education than bad-type employees. The cost he refers to is not necessarily the cost of tuition and living expenses, sometimes called out of pocket expenses, as one could make the argument that higher ability persons tend to enroll in "better" (i.e. more expensive) institutions. Rather, the cost Spence is referring to is the opportunity cost. This is a combination of 'costs', monetary and otherwise, including psychological, time, effort and so on. Of key importance to the value of the signal is the differing cost structure between "good" and "bad" workers. The cost of obtaining identical credentials is strictly lower for the "good" employee than it is for the "bad" employee.
The differing cost structure need not preclude "bad" workers from obtaining the credential. All that is necessary for the signal to have value (informational or otherwise) is that the group with the signal is positively correlated with the previously unobservable group of "good" workers. In general, the degree to which a signal is thought to be correlated to unknown or unobservable attributes is directly related to its value.
The result 
Spence discovered that even if education did not contribute anything to an employee's productivity, it could still have value to both the employer and employee. If the appropriate cost/benefit structure exists (or is created), "good" employees will buy more education in order to signal their higher productivity.
The increase in wages associated with obtaining a higher credential is sometimes referred to as the Sheepskin Effect, since "sheepskin" informally denotes a diploma. It is important to note that this is not the same as the returns from an additional year of education. The "sheepskin" effect is actually the wage increase above what would normally be attributed to the extra year of education. This can be observed empirically in the wage differences between 'drop-outs' vs. 'completers' with an equal number of years of education. It is also important that one does not equate the fact that higher wages are paid to more educated individuals entirely to signalling or the 'sheepskin' effects. In reality education serves many different purposes to individuals and society as a whole. Only when all of these aspects, as well as all the many factors affecting wages, are controlled for, does the effect of the "sheepskin" approach its true value. Empirical studies of signalling indicate it as a statistically significant determinant of wages, however it is one of a host of other attributes — age, sex, and geography are examples of other important factors.
One of the consequences of the existence of a pure signalling value to education is that public funding of education, especially higher education, is questioned. The debate is not so much about whether there should be any public funding at all; but what the correct level of funding should be. In purely economic terms, the optimal level of public funding would equal the total public benefits from the educated population — the private value of the signal would be excluded.
Signalling and IPOs 
Leland and Pyle (1977) analyse the role of signals within the process of IPO. The authors show how companies with good future perspectives and higher possibilities of success("good companies") should always send clear signals to the market when going public (e.g. the owner should keep control of a significant percentage of the company). To be reliable, the signal must be too costly to be imitated by "bad companies". If no signal is sent to the market, asymmetric information will result in adverse selection in the IPO market.
- Michael Spence (1973). "Job Market Signaling". Quarterly Journal of Economics (The Quarterly Journal of Economics, Vol. 87, No. 3) 87 (3): 355–374. doi:10.2307/1882010. JSTOR 1882010.
- Michael Spence (2002). "Signaling in Retrospect and the Informational Structure of Markets". American Economic Review 92 (3): 434–459. doi:10.1257/00028280260136200.(also available as his Nobel Prize lecture PDF)
- Andrew Weiss (1995). "Human Capital vs. Signaling Explanations of Wages". The Journal of Economic Perspectives 9 (4): 133–154.