signaling,+screening

=Signaling and Screening -- by Samir Pipalia=

At the beginning of 2001, The Enron Corporation was one of the largest energy companies in the world. It was also considered a blue chip stock in the stock market. Its profits were up, stock price was going up and it was making unprecedented leaps in its industry. All that was lost by the end of the year. The revelations made that brought about the downfall of Enron Corporation and its Accountants, Arthur Andersen were shocking. It shook the whole financial industry and hundreds and thousands of people lost their jobs and lost a lot of money they had invested in Enron. It was revealed that Enron had falsely reported their earnings and profits and in order to cover up, most of their top line management either quit or sold their stocks in the market before Enron was going down. As a result, the company filed for bankruptcy and most of its top bosses faced charges of bank fraud, securities fraud, money laundering, conspiracy and insider trading.

WorldCom was a giant in the telecommunication industry. After its acquisition by MCI, due to industry downturn, WorldCom’s growth suffered and its stock price fell. Under pressure from its investors, the company under the direction of its CFO used fraudulent accounting methods to cover its dwindling financial condition and began to report false growth and profitability in order to increase its stock price. They inflated their revenues and capitalized costs rather than expensing them. It was reported that their total assets were bloated to a whopping $11 billion. When the fraud came out, the company filed for bankruptcy, the largest in US history.

Martha Stewart, was convicted of charges of Insider trading and selling her stocks of the pharmaceutical company ImClone through information she had received from people within the company. The company had sent its Cancer drug for approval from the Food and Drug Administration. The founder of the company, Samuel Waksal who was friends with Martha Stewart, is tipped that the government would not approve the cancer drug. As a result she was tipped that Waksal was trying to sell all his shares and as a result sold all of her shares of ImClone. When the FDA made its decision public, ImClone’s stock fell by 18%. Although Stewart insists that she had a stop-loss on her stocks, although it was proved otherwise that she had inside information of the findings and was tipped to sell her stocks.

The above are some of the example of asymmetric information where firms and individuals have taken advantage of the hidden information that they possessed for their own benefit and create uncertainty in the market. The above situations are examples of moral hazard (Enron, WorldCom, Arthur Andersen, Martha Stewart used hidden information for their own benefit). These issues could be resolved by the use of Signaling. Whereby informed parties disclose their hidden information to uninformed individuals. It is discussed in detail below.

Signaling
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”. In our above examples of Enron and WorldCom, in order to avoid accounting losses, the bosses of the two firms hid the shortcomings of their company and sent out the wrong signals to its investors. Both firms by their actions signaled to their investors that they are doing well and misled them. Arthur Andersen too, the external auditors for both Enron and WorldCom had the information and was also part of the whole fraud involving the two firms. KPMG on the other hand after taking over from Arthur Andersen for WorldCom, reported the false information sent out and made it public. Thereby sending out the correct signals and protecting thousands of investors from making the wrong decision.

For a signal to provide useful information, it must be observable by the uninformed party. It must be a reliable indicator of the underlying unobservable characteristic and difficult for parties with other characteristics to easily mimic. For example, as an MBA graduate from the Miller College of Business, you are sending out a signal to employers that you have a Graduate degree. When competing with other candidates for the same job, very few will be able to mimic an MBA unless they too have the degree. You are therefore sending out a signal to your employers that you have an advanced degree which will distinguish you from other candidates that do not.

Screening
Screening is an attempt by an uninformed party to sort individuals according to their characteristics. This can be achieved through a self-selection device. A mechanism in which informed parties are presented with a set of options, and the options they choose reveal their hidden characteristics to an uninformed party.

One of the most important kinds of information concerns the qualities of a factor or a commodity. As we saw in the “Lemon Experiment”, when information was not presented to us, it was difficult to distinguish between high-quality and low-quality mp3 players. We know that there are important differences among individuals, among bonds, among equities, among brands of automobiles. The identification of these qualities we call screening, and the devices that sort our commodities (individuals) according to their qualities we call as screening devices.

In labor markets, information provided by screening processes helps identify more productive workers. Therefore individuals that can be labeled as “more productive” are able thereby to obtain higher wage, at the expense of others. Thus, screening information has important effects on distribution of income. In our aplia quiz of Markets with Asymmetric Information II, question 4 showed to us how the firm used education to screen between its productive and lazy workers. Workers enrolled in the class and getting a passing grade would get higher salary than those that are not enrolled. The informed parties in this case are the workers who know their productivity. Productive workers would take the class and would work hard to pass it as well. Therefore they use the self-selection device to show their productivity and hence get paid more for their efforts. Using this screening process, the firm distinguishes between productive and lazy workers.

Questions
1. What is signaling? a. Action taken by one party in a relationship that cannot be observed by the other party b. Situations where individuals have hidden characteristics and in which a selection process results in a pool of individuals with undesirable characteristics c. Things one party to a transaction knows about itself but which are unknown by the other party d. An attempt by an informed party to send an observable indicator of his or her hidden characteristics to an informed party

2. What is screening? a. A mechanism in which informed parties are presented with a set of options, and the options they choose reveal their hidden characteristics to an uninformed party b. An attempt by an uninformed party to sort individuals according to their characteristics c. Situation where one party to a contract takes a hidden action that benefits him or her at the expense of another party

3. You are an employee at a firm and constantly take certifications to increase your knowledge base and distinguish yourself from others? How are you sending this information to your manager? a. Signaling b. Adverse Selection c. Screening d. None of the above

4. Many universities across the world offer merit-based scholarships to its students. What system are they using to distinguish between high performance students and average students? a. Signaling b. Moral Hazard c. Screening d. Both a and c

5. The example above of Martha Stewart taking advantage of inside information that she received for her own benefit is an example of a. Adverse selection b. Moral Hazard c. Profit Maximization d. Self-selection

Answers
1. [d] Option a is the definition of hidden action. Option b is the definition of adverse selection, option c is the definition of hidden characteristics. 2. [b] Option a, is the definition of signaling and c is called moral hazard. 3. [a] You are trying to prove to signal to your manager that your skills are better than some of the others through the certifications that you take. 4. [C] Universities use the screening method since those students who perform well will get the scholarship and they will know their good students from the average. 5. [b] Moral hazard because Martha Stewart actually acted on the information she received.