Keystrokes of the ‘faint-hearted’ closet economist: Signalling & Brands

The concept of signalling has to do with the transfer of information from one party to another, often in order to achieve some sort of mutual satisfaction or arrangement. When explaining the way that signalling occurs, the party that is transmitting the information is often referred to as the agent. The party that receives and evaluates the information is usually understood to be the principal.

One of the classic illustrations of how signalling works involves an individual who is seeking employment. In order to attract the attention of an employer, the prospective employee may choose to engage in signalling as a means of gaining the attention of the employer. This segment of the process often begins with the crafting of the resume. If the information on the resume generates sufficient interest, then the employer will often schedule an interview and seek to broaden his or her knowledge base about the prospective employee.

At the interview, the prospect assumes the role of agent and seeks to build on the rapport already established through the resume. This will involve emphasizing certain facts that are relevant to the position and the general goals of the company. Essentially, the agent is taking true data and presenting it in the most attractive manner possible.

In turn, the employer assumes the role of principal and receives the information. As the information is received, principals assimilate and evaluate the data. At the end of this process, the principal can extend an offer of employment to one agent, as well as inform other agents that there is no need for further information and the position is now filled.

One of the key components of ethical signalling is that only true and correct information is provided by an agent to a principal. While the agent may choose to downplay some data while spotlighting other information that he or she believes is of more interest to the principal, honesty is essential if the conveyance or signal of information is to be considered successful.

When a person buys a used car from a stranger, the buyer knows that the purchase involves risks. The seller may tell him that the car has always worked well, but the buyer cannot be sure that the seller is truthful. It is in the interests of the seller to say these things, whether or not they are true. The seller of a “lemon” could say the same thing as the seller of a quality item. Economists say that markets in which one side of the transaction has better knowledge than the other, as in this case, have asymmetric information. In this example sellers of quality items need a way of communicating information to buyers so that only truthful information will be transmitted.

How do sellers convince buyers of the attractive qualities of their products? Or how do buyers seek to filter out erroneous information? Sellers of high-quality items must find a way to signal information about their products, and these signals must be difficult for those selling low-quality products to duplicate.

The way firms signal quality is by building a brand. A brand is valuable only if consumers associate it with quality, and the firm can build this association only with time and resources. Once a brand is established, it is in the interests of the firm to protect it by not offering a poor-quality product.

When consumers are uncertain about product attributes, firms use brands to inform consumers about product positions and to ensure that their product claims are credible(and that there is no information asymmetry.) Brands as market signals improve consumers’ perceptions about brand attribute levels and increase confidence in brands’ claims. The reduced uncertainty lowers information costs and the risks perceived by consumers thus increasing consumers’ expected utility.

What makes a brand?

So the battle over brands will go on. Do not be fooled into thinking it is really about mobile phones, cars or shampoos. It is all about information. And it will continue for as long as buyers need and want information.

PS: Signalling is one of the most seminal works of the economist, George Akerlof who spent a considerable amount of time in India while working on his various theses.

Signalling has been widely used by marketing researchers to understand brand equity and building brand extensions using an umbrella brand as a linchpin.

NEXT POST -> The economic principle that fuels the multi-billion dollar internet advertising industry.

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