Signaling and Screening

In most instances involving contracts each contracting party brings with him or her to the relationship certain valuable information which the other contracting party is unaware of. This scenario is referred to as asymmetric information; a situation in which one individual has better information than the other. To better illustrate this topic we will examine the concept of asymmetric information, as well as related topics, in the light of the employment process.

Returning to the topic of asymmetric information, it is common, as well as expected, that a job applicant possesses more information about his or her qualifications, experience, and work history than the employer does. This information which is owned by the applicant, can also be refered to as "hidden characteristics"; defined by Michael Baye as “Things one party to a transaction knows about itself but which are unknown by the other party.”

Given what we have learned thus far regarding asymmetric information and hidden characteristics it is easy to see how these two concepts can pose as significant barriers to engaging in any type of contractual relationship. Those wishing to enter into a contractual relationship are faced with a quandary. The employer desires to hire well-qualified individuals who posses a strong work ethic and a high level of integrity. Yet, the employer cannot easily differentiate between applicants. It is not easy for the employer to measure applicant’s work ethics or integrity. Conversely, the job applicant wishes to align himself with a firm that treats its employees fairly and rewards effort based on merit and performance. However, similar to the employer’s predicament, the applicant cannot very easily distinguish between good employers and bad employers. Since both contracting parties lack critical information about the other, both would be understandably reluctant to engage in a relationship with each other. Fortunately, this dilemma can be solved through the utilization of the economic concepts known as signaling and screening.

To overcome the dilemma described above one party could share information about his or her hidden characteristics with the other contracting party. By sharing critical information the contractual foundation can be laid. According to Baye signaling is “an attempt by an informed party to send an observable indicator of his or her hidden characteristics to an uninformed party.” For the job applicant this could mean conveying information to the employer about education, skills, or work experience; any information which could help to separate and distinguish an applicant from competition. From the employer perspective, the hiring organization may tout any awards or recognition received relative to working conditions or company culture. For example, Starbucks often touts that it has received numerous awards by Fortune Magazine as a great place to work. USAA insurance advertises that Business Week Magazine has recognized it as one of the best companies in America to work for.

For a signal to truly be effective it should not be easy to replicate. From the perspective of the applicant, a degree or a professional designation is not easy to obtain. Therefore, these types of credentials may effectively signal to others that the holder has managed to separate himself from others. The employer is thus presented with some level of assurance. Conversely, from the employer perspective, an award for a great workplace is not easy to obtain. Thus presenting this information to an applicant should help to ease any concerns regarding the organization’s culture.

An interesting example of signaling involves Marine Corps recruits. For quite some time the Marine Corps has refused to admit anyone with a G.E.D. However, the Marine Corps will on ocassion admit recruits who did not graduate from High School. The caveat is that the potential recruit must have “sat-through” his or her fourth year of high-school. The recruit has to provide rigorous documentation from their guidance counselor that he or she indeed made a very strong and consistent effort to attend classes daily. The Corps’ rationale is that obtaining a G.E.D. is “the path of least resistance”; whereas sitting through classes for 7 hours a day, for 35+ weeks is more difficult. For the recruit who chooses the latter, this activity sends a signal that the recruit is able to see things through to completion despite challenging obstacles. Additionally, this activity on the part of the recruit cannot be replicated without substantial effort, proving this activity is an effective signaling mechanism.

In addition to signaling, another tool which can be used to overcome information asymmetries is the screening. Screening is a process whereby those with an information disadvantage attempt to sort individuals by certain characteristics, thereby giving the person performing the sorting greater information about individuals desiring to enter into a contractual relationship. Within the employment arena screening mechanisms may include background searches, behavioral-based interviewing techniques, and even poly-graph tests.

Screening may also involve the use of self-selection devices. Self-selection devices present individuals with a set of options to choose from. The options chosen by the individual reveal information about themselves to others. An interesting self-selection device used by this author’s employer involves web-based hiring applications. My employer no longer allows applications to be completed by hand. An interested job candidate must connect to my company’s website and complete the on-line application. The objective is to automatically disqualify those individuals that do not posses basic computer and web-related skills. By only accepting web-based applications my employer has some level of assurance that the candidate possess basic computer and internet skills.

In this essay we limited our discussion of signaling and screening to employment-based contractual relationships. However, these tools can be used to overcome asymmetric informational difficulties in any type of contractual relationship. For example, manufacturers can market their products with warranties, to better convey a product’s quality to consumers. Home-buyers can obtain pre-approval, to assure lenders and builders that they can actually afford to purchase a home. Insurance companies use rigorous screening techniques when they provide automobile and homeowner premium quotes to customers.

Review Questions

1. A tool which allows individuals to select from a set of options, which ultimately reveals information about themselves is refered to as
A) Filter
B) Self-Selection device
C) Signal Transmitter

2. Background searches, refrence checks, credit checks, and job questionaires are all generally refered to as
A) Self-Selection devices
B) Screening methods
C) Signalling methods

3. What is the most effective method to employ to overcome information assymetry?
A) Signalling
B) Screening
C) A or B

4. Which of the following is an effective signal:
A) Possessing an MBA
B) Background check
C) Residing in Carmel, IN

5. True or False; Assymetric Information and Hidden Characteristics are two sides of the same coin:
A) True
B) False


"Managerial Economics and Business Strategy", Michael Baye