The word signal comes from the Latin word signum, meaning “sign,” and from the Late Latin word signalis, meaning “of a sign.” A signal is an event, message, activity, or, generally, any means of communication that encodes or transmits a message or some information between at least two parties, the sender and the receiver of the message.
In economics, a signal is a means by which one party (the agent) conveys some meaningful information about itself to another party (the principal). The action of sending a signal is called signaling. In business, a signal is a means by which a firm conveys to the market (investors, financial analysts, banks, bondholders, stockholders, and all stakeholders) information about its current position and future prospects.
In a perfect market, all information is accessible to all at zero cost and simultaneously. However, markets in reality are not perfect and manifest a deviation from perfect information called asymmetric information. In some economic transactions, the participants have different access to information pertinent to their decision-making: One party has more or better information than the other, and this inequality of information access disrupts normal market behavior. Michael Spence (1973, 2002) suggests that two parties with different exposure to needed information could overcome this problem of asymmetry by having one party send a signal to the other, revealing some pertinent information. The receiving party could interpret this signal and adjust their behavior accordingly. Interpretation, of course, is subjective and can lead to erroneous inferences. Thus, there is need for a lot of caution in signal interpretation.
There are types of sellers who usually have better information than buyers, such as used-car dealers, salespeople, mortgage brokers, loan originators, stockbrokers, real estate agents, and company insiders (managers). There are also circumstances in which the buyer usually has better information than the seller, such as estate sales as specified in a last will and testament, sales of old art pieces without prior professional valuation, and purchases of health insurance by consumers (or clients) with various risk levels. Asymmetric information can result in one party being defrauded by the other. Because information is easy to create and spread, but difficult to control and trust, it complicates many standard economic theories.
In finance, signaling theory has been applied to the problem of asymmetry of information between a firm’s insiders (managers) and outsiders (stockholders, stakeholders, bondholders, and investors). This theory mainly concerns two aspects of a firm’s strategic decisions: capital structure and dividend policy decisions. Stephen Ross (1977), the first to apply signaling theory to finance, argues that the market values a firm’s perceived returns, not its actual returns. Managers, as insiders, have monopolistic access to pertinent information about a firm’s prospects and expected cash flows. Therefore, when it is in their strategic interest, they can use project financing or dividend policy to send signals to investors about their firm’s future. For instance, increased financial leveraging can be used by managers to signal optimistic future prospects. Hayne Leland and David Pyle (1977) assume that owners (entrepreneurs) have better information about the expected value of their firms’ future investment projects than outsiders have. If a firm increases its dividend payout, this is perceived as a positive signal about expected future cash inflows. The market interprets this increase as a sign that the firm will be able to generate enough cash inflows to cover all its debt payments and its dividend payments without increasing the probability of bankruptcy (see Fama, Fisher, Jensen, and Roll 1969; Asquith and Mullins 1983; Richardson, Sefcik, and Thompson 1986).
SEE ALSO Finance; Information, Asymmetric; Information, Economics of; Screening and Signaling Games
Asquith, Paul, and David W. Mullins Jr. 1983. The Impact of Initiating Dividend Payments on Shareholders’ Wealth. Journal of Business 56 (1): 77–96.
Fama, Eugene F., Lawrence Fisher, Michael C. Jensen, and Richard Roll. 1969. The Adjustment of Stock Prices to New Information. International Economic Review 10 (1): 1–21.
Leland, Hayne E., and David H. Pyle. 1977. Informational Asymmetries, Financial Structure and Financial Intermediation. Journal of Finance 32 (2): 371–387.
Richardson, Gordon, Stephan E. Sefcik, and Rex Thompson. 1986. A Test of Dividend Irrelevance Using Volume Reactions to a Change in Dividend Policy. Journal of Financial Economics 17 (2): 313–333.
Ross, Stephen A. 1977. The Determination of Financial Structure: The Incentive-Signaling Approach. Bell Journal of Economics 8 (1): 23–40.
Spence, Michael. 1973. Job Market Signaling. Quarterly Journal of Economics 83 (1): 355–374.
Spence, Michael. 2002. Signaling in Retrospect and the Informational Structure of Markets. American Economic Review 92 (3): 434–459.