Introduction

Another market response to the problems of adverse selection is signaling. Here, the informed party makes a first move and attempts to reveal his or her private information by signaling his or her type. Regarding the labor-market application, we allow workers to signal their productivity with their educational achievements.

Signaling is also widespread outside the realm of education. For example, a joint stock company may issue debt instruments in lieu of equity in order to indicate to potential shareholders that the market underestimates its future earnings. Similarly, a firm may engage in costly advertising just in order to tell its customers or rivals that it is not a fly-by-night outfit. Or a monopolist may choose a high-cost product supply – despite forgone monopoly profits – just in order to warn potential entrants that they face a low-cost supplier (see Milgrom and Roberts (1982a, 1982b)). In animal populations, high-quality males may advertise their quality by displaying handicaps, such as a longer tail or brighter plumage, that make it more difficult to survive.

In the following, we consider one particular signaling model, Spence's (1973) justly famous job-market signaling, and we state it explicitly as a noncooperative game. As it turns out, the analysis requires the employment of several advances in game theory.