Introduction: The importance of credible signals
The seller of a used car knows the history and quality of the car much more than the buyer who walks into the show room. The used car salesman could moderate the buyer’s suspicions by offering a warranty on the used car. Here the salesman is using a signalling tool, the warranty, to tell the buyer he has confidence that the used car will work well over the warranty period. Described here is one of the classic examples of the asymmetric information problem, which is a problem that occurs when one side of the market knows more than the other side. Many private markets are affected by this problem; for example the loan market, insurance markets, real estate market, and the labour market. The participants in these markets have evolved market-based solutions to these problems and sometimes the government is needed to intervene to protect consumers from information problems. Signalling in various forms is one of the market-based methods to ease problems associated with the imbalance in information.
The same principle of asymmetric information is rife with
