Signalling: The Unspoken Language We Use Everyday

Not having enough information is a problem. 

George Akerloff was the first to detail this. In his Nobel-winning paper, The Market for Lemons, he observed that markets with asymmetric information would eventually collapse.

Because only sellers would know the condition of the goods they sold, they could always mask defective products — lemons — as quality products and charge buyers the higher price for them. To protect themselves, buyers had to price in the above possibility they would end up with a lemon. This meant assuming that they were likely being offered an average product, and should pay no more than what it could command. 

You can imagine what an inefficient system this was. As buyers offered lower prices, sellers started to offer even lower quality products. With each feedback loop, the market for goods deteriorated. Nobody got anything of value from transacting in that good. The market is left to collapse. 

The startling thing is that the bad often drives out the good. 

Honest sellers who would never mask a lemon as a quality product are forced to leave the market because they won’t get fair value for what they offer. It’s the rogues and charlatans who stay because they know they can profit off this information asymmetry. The exact opposite of what we want.

Mandatory disclosure laws aim to solve this problem. It’s the only way fields like insurance and finance could ever function. Even then, sometimes they fail. People skirt around or these laws. Or they lie outright.

There’s another way that we convey information. Signalling is how we tell other participants in the marketplace that we are trustworthy sellers. Because remember, even honest and trustworthy sellers are driven out of the market if buyers aren’t aware that they’re the real McCoy. 

It’s not only a solution to an economic problem, but also a biological and social imperative. You and I both signal, whether we know it or not. As Geoffrey Miller writes in Spent: Sex, Evolution and Behaviour:  

“Fitness indicators are signals of one individual’s traits and qualities that are perceivable by other individuals. The animals that possess them are not consciously aware that these traits evolved to advertise their fitness. They just have the genes and instincts for displaying them, and evolution itself keeps track of the survival, social, and sexual benefits of doing so. We humans may not have much more conscious insight into the biological functions of our fitness indicators than guppies have into the functions of their flaglike tails”

For better or worse, signalling is here to stay. 

Each of us has information we want to convey for our own purposes. Signals are not meant to benefit society at large. This creates a huge problem because we don’t know how to pick up a good signal amidst all the noise. 

A few lessons that we can learn here.

1. If an efficiency is never fixed or punished, there’s a good chance that signalling is at play. 

Higher education is broken. 

You pay $50,000 a year for classes you rarely attend, to learn things that are not applicable in the working world, and spend the next 20 years paying off your student debt. In exchange, you get an experience you can bring up at conversations, the chance to build a network, and a pretty certificate. 

That last bit is important. It’s also why we continue to go through the college process. Signals are powerful, and they can take many forms. As Bryan Caplan explains in The Case Against Education

“Imagine this stark dilemma: you can have either a Princeton education without a diploma, or a Princeton diploma without an education. Which gets you further on the job market? For a human capital purist, the answer is obvious: four years of training are vastly preferable to a page of paper. But try saying that with a straight face. Sensible versions of the signaling model don’t imply the diploma is *clearly* preferable; after all, Princeton teaches *some* useful skills. But you need signalling to explain why choosing between an education and a diploma is a head-scratcher rather than a no-brainer.”

This isn’t new. Researchers have known since at least 1973 that college graduates command a wage premium. It’s only more recently that we’ve become more certain that this premium is due to the degree as a signal, and not the skills that we’ve learnt in college. 

The same applies in our consumption patterns. Why does anyone buy the latest phone model that is only marginally better than the previous one but costs almost twice as much? Or pay a premium for an imported car that has the same technical specifications as one that’s domestically produced? 

You might say the answer is taste, but dig deeper and there’s a more insidious reason: status. Inefficiencies in pricing or supply might turn away the average consumer. But for those with desirable qualities — those with the goods —  that’s not an object. These people can afford to internalise such inefficiencies. And they want to show it. 

Take a peacock for example. Peacock tails require a lot of energy to grow and carry around. They draw the attention of predators. From an evolutionary perspective, they are an absolute burden to bear. But from a mating perspective, the peacock tail serves as a great indicator of fitness. The reason is counterintuitive yet simple: unhealthy, unfit peacocks can’t afford these tails. Only a healthy peacock could grow one like that, and if I’m a female peacock, I’m going to look for a male who has the biggest and brightest tail. 

Inefficiencies usually exist as a matter of accident. But if it’s been around long enough, consider that it’s been left there intentionally. 

Scarcity and exclusivity is one such intentional inefficiency. Berghain doesn’t turn people away from its doors for no reason. Ditto for Hermes, which limits its production of Birkin bags to just 12,000 a year. Same goes for top schools like Harvard and Yale, which limit admission to only a small group. 

All of these brands offer quality products and experiences. You’d think that more people should have the chance to access them. But if the management of either of these organisations tripled their offerings, they’d be fired immediately. That’s how you know the inefficiency is intentional. 

Once you understand signalling, you see it everywhere.

2. Not all signals are created equal. 

If you’re playing poker with someone who shouts that he has a straight flush, you wouldn’t pay him any attention. But if he raises you a large amount, you should reweigh your odds of winning. 

Talk is cheap. The most credible signals are those that are costly, where the person sending them has skin in the game.

It’s also why, according to Rory Sutherland, you never have to worry about bad behaviour from a London black cab driver:

“If you’re prepared to spend four years becoming a cab driver, and four years of your life that you’ll never get back is spent reaching that qualification, you’re plainly committed to the job. Secondly, you have a lot of skin in the game, because it’s not worth losing that badge for the sake of ripping off a random Canadian going from Heathrow to gain ten quid. It’s just not worth the risk. As a reliable gauge of honest intent, you can trust a Black Cab driver in a way that you couldn’t if the qualification had simply demanded two weeks of night school. In many ways, these are trust placebos.”

Incentives matter. When it comes to human behaviour, no other force has quite the same impact as incentives. This is why salesmen and executives have most of their compensation tied to their performance. Their employers and shareholders know that this is the best way to ensure that they work hard. Like it or not, this has become the norm. 

For the same reason, I’m going to trust someone more if he asks to have a large, if not entire, portion of his compensation tied to his performance. This person is saying, “I am so good at my job that conventional compensation practices will hold me back. Let me eat what I kill, or not eat at all.” There’s no stronger signal than owning your downside.

Sure, this too can fail. Just like in poker, people bluff. Or they might be irrationally confident in their own hand or ability. Yet, skin in the game continues to be the most reliable signal around. Ask Taleb and he’ll tell you it’s necessary for fairness, commercial efficiency, risk management, and for understanding the world. 

Ask a used car salesman for a warranty and you’ll see why Taleb is right. 

3. Signals can mislead you into playing stupid games.

Management expert Peter Drucker popularised the line that “what gets measured gets managed.” Economist Charles Goodhart theorised that when a measure becomes a target, it ceases to become a good measure.

Add the two together to signalling and you realise why Einstein thought that human stupidity was infinite.

Signals are proxy indicators of a characteristic that we’re looking for. They aren’t the end goal. When you optimise for a signal, you sacrifice other outcomes that are just as important. Motivated students know that test scores are more important than actual learning if they want to get into an Ivy league university, and they’ll prioritise getting that everyday.

Make no mistake, it’s also a double whammy. 

Not only do you waste resources that don’t give you your desired outcome, but it also causes the signal as a reliable indicator to fail. Someone then has to figure out a better signal, and it’ll last for awhile before it gets gamed. The cycle repeats.

Companies spent $240 billion on advertising in the US alone last year. The reason they do that is because it works. Consumption is now not only based on need, but based on aspiration as well. We each buy products to signal our tastes and personal qualities, all participants in a zero-sum game of status. 

There’s an iconic scene in Fight Club where everyone gathers around Tyler Durden to hear him speak. There he sums up modern life better than anyone else could:

“God damn it, an entire generation pumping gas, waiting tables; slaves with white collars. Advertising has us chasing cars and clothes, working jobs we hate so we can buy shit we don’t need.”

Play stupid games, win stupid prizes.