Question

Say whether each of the following situations involves screening or signaling. [LO 10.4\(]\) a. Auto shops and motels advertise that they are AAA-approved. b. Employers check interviewees' Facebook or MySpace profiles before hiring one of them. c. Applicants must pass an exam before becoming eligible for a civil service position. d. People wear expensive clothing with large brand names or logos.

Short answer

a. Signaling, b. Screening, c. Screening, d. Signaling.

Step-by-step solution

Understanding Screening vs. Signaling

Screening is an action taken by one party to uncover information about another party. Signaling is a way for one party to credibly reveal information about themselves to another party.

Situation Analysis: AAA Approval for Auto Shops and Motels

When auto shops and motels advertise that they are AAA-approved, they are engaging in signaling. They are trying to communicate and assure consumers of their quality by displaying AAA's endorsement.

Situation Analysis: Employers Check Social Media Profiles

Employers checking interviewees' Facebook or MySpace profiles is an example of screening. The employer is seeking additional information from the applicants' profiles to make more informed hiring decisions.

Situation Analysis: Exam for Civil Service Positions

Requiring applicants to pass an exam for civil service positions is an instance of screening. The exam helps the employer (government) distinguish between qualified and unqualified candidates.

Situation Analysis: Wearing Expensive Clothing with Logos

People wearing expensive clothing with large brand names or logos are engaging in signaling. They are attempting to communicate their wealth and taste to others, using brand names as a signal.

Key concepts

Information Asymmetry

Information asymmetry is a situation where one party in a transaction has more or better information compared to the other party. This often occurs in markets where one side (such as buyers or sellers) may conceal or reveal information to gain an advantage. Information asymmetry can lead to problems like moral hazards or adverse selection, affecting the balance of transactions.
Imagine you're buying a used car. The seller knows the car's history well, but you might not. This discrepancy in information might lead you to make decisions that aren’t in your best interest.
To combat information asymmetry, two strategies are often employed: **screening and signaling**. Screening is done by the party with less information to uncover more, while signaling is used by the party with more information to credibly share what's known.

• **Screening**: Employers reviewing social media profiles for better hiring decisions.
• **Signaling**: Motels displaying a AAA approval to assure quality.

Labor Market

The labor market is a major arena where screening and signaling play vital roles, particularly during the hiring process. Employers often face the challenge of information asymmetry—they don’t know if a potential employee will perform well.
To minimize this gap, employers use screening methods like background checks or exams. These steps help them gather more information about candidates' skills and behaviors. For example, requiring an exam for civil service positions allows employers to see who is most qualified.
Conversely, potential employees use signaling to showcase their skills and reliability. They might use resumes, degrees, or references as signals to demonstrate their capabilities.

• **Screening**: Checking interviewees' educational qualifications.
• **Signaling**: An applicant presenting a professional portfolio during an interview.

Consumer Behavior

Consumer behavior is heavily influenced by information asymmetry. Consumers often make purchase decisions based on perceived value, brand reputation, and signals conveyed by products.
When consumers face incomplete information, they rely on signals from sellers to make decisions. For example, people wearing clothing with big brand logos signal their fashion sense and financial status to peers, influencing others' perceptions.
Conversely, brands use signaling to establish credibility and trust among consumers, such as through quality certifications or endorsements, like a AAA approval, to indicate reliability.

• **Signaling**: Using celebrity endorsements to appeal to a target audience.
• **User-generated content**: Consumers providing reviews or testimonials as forms of organic signaling.

Economic Theory

Economic theory helps explain the dynamics of screening and signaling under the framework of markets and decisions. It acknowledges that these concepts exist to address issues where markets don’t function perfectly due to asymmetric information.
In theory, signaling can reduce information asymmetry, allowing markets to reach more efficient outcomes. Firms that signal their product as high-quality can potentially achieve better prices. On the other hand, screening by consumers ensures only quality products or candidates receive their time and money.
These strategies help in determining equilibrium in markets where direct observation of product or service quality isn't possible until post-purchase. By managing information asymmetry, participants can better align expectations and actual outcomes, leading to improved trust and satisfaction.

• **Adverse Selection**: Mitigated by appropriate screening, ensuring the right participants are in the market.
• **Moral Hazard**: Addressed through signaling, aligning actions with proclaimed intentions.