Saturday, 29 April 2017

Why all students need to understand adverse selection and signalling

Of the economic concepts we cover in ECON100 and ECON110, adverse selection is one of the most deceptively difficult problems to explain. It is easy to understand that some people simply know some things that others don't (economists call that private information, and when there is private information we also say that there is information asymmetry). However, in order for there to be an adverse selection problem, the private information needs to lead to market failure in some way, and explaining the market failure is more difficult than explaining the private information. Not all private information leads to market failure, and the market failure is the reason why we need to have ways of dealing with the adverse selection problem. Since the problem stems from private information, solving an adverse selection problem involves revealing the private information to the uninformed party. When the informed party (the one that knows the private information) tries to credibly reveal that information, economists call that signalling.

Students are engaging in a sophisticated array of signals, on multiple levels. It's not possible to avoid signalling in this case, since trying not to provide a signal is itself a signal. The problem that this signalling is trying to avoid stems from private information about the quality of the student - students know whether they are high quality (intelligent, hard working, etc.), but employers don't. Employers want to hire high-quality applicants, but they can't easily tell them apart from the low-quality applicants. This presents a problem for the high-quality applicants too, since they want to distinguish themselves from the low-quality applicants, to ensure that they get the job. In theory, this could lead the market to fail, but in reality the market has developed ways for this private information to be revealed.

One way this problem has been overcome is through job applicants credibly revealing their quality to prospective employers - that is, by job applicants providing a signal of their quality. In order for a signal to be effective, it must be costly (otherwise everyone, even those who are lower quality applicants, would provide the signal), and it must be costly in a way that makes it unattractive for the lower quality applicants to do so (such as being more costly for them to engage in).

Qualifications (degrees, diplomas, etc.) provide an effective signal (they are costly, and more costly for lower quality applicants who may have to attempt papers multiple times in order to pass, or work much harder in order to pass). So by engaging in university-level study, students are providing a signal of their quality to future employers. The qualification signals to the employer that the student is high quality, since a low-quality applicant wouldn't have put in the hard work required to get the qualification. Qualifications confer what we call a sheepskin effect - they have value to the graduate over and above the explicit learning and the skills that the student has developed during their study.

However, there are actually multiple levels of signalling associated with university study. Employers are faced with many applicants that have similar qualifications, and it is difficult to distinguish who, among those with the qualification, is the better applicant. So, the choice of major provides an additional signal to employers. Some majors are clearly more difficult than others - students who can complete a degree while majoring in more difficult majors are signalling to employers that they higher-quality employees than students who complete a degree with easier majors. I leave it up to you to determine which majors might be easier, and which might be more difficult.

Within majors there is a further signal, which is the student's choice of papers. Taking economics as an example, econometrics is likely to be the most difficult paper that students will take. So, students who complete an economics major without completing an econometrics paper are signalling to employers that (among economics graduates) they are the lower-quality economics graduates. [*] I'm sure there are certain papers within other majors that are perceived as difficult and provide a similar signal for students taking those majors.

Within papers there is a yet another signal, which is the grade the student receives. It is harder to get an A than to get a C, so the grade a student receives in any paper also provides a signal of student quality to employers. The saying goes that "C's get degrees", which may be true, but students with C's don't get their first choice of jobs (or at least, they have a lesser chance of getting the good jobs).

But there is still one more signal that students engage in, which isn't a signal to employers but a signal to their lecturers. Just like employers, lecturers don't know who the high quality students are (remember this is private information). So, how students engage in class, and how they perform in assessments, is a way for the students to signal their quality to lecturers. Students who don't complete some assessment items, or who don't attend lectures or tutorials, or who don't complete online tests, and so on, are providing a signal to their lecturers and it's not a signal of their high quality. Even avoiding a small piece of assessment, or an optional task in class, is a signal to the lecturer. And that signal may make the difference between an A and B grade, or between a pass and fail. Which in turn becomes a signal to employers, as noted above.

So, students are generating many signals (by completing a qualification, by their choice of major and individual papers to include in their qualification, by their grades in those papers, and by how they engage and perform within each paper). All of which means that every student needs to understand adverse selection and signalling. Otherwise, they might just end up providing the wrong signals.


[*] Which is why I recommend to economics majors that they include econometrics in their programme of study, even though it is not compulsory.

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