LET’S assume that you are waiting for a friend at an assembly point and a well-dressed person gets out of an expensive sports car and approaches you. You address him as ‘Sir’ because, subconsciously, a fancy suit and an expensive car are indicators of a person’s wealth. They are aimed at imparting information about the signaller to the signal receiver.
This theory is a component of a game theory widely known as Signalling Theory, which investigates and analyses the nature of the communication behaviour. Signalling Theory also applies in the job market in which, upon completion of a university degree, graduates would search for jobs relevant to their fields of study.
Asymmetric information is a situation where one party has more or superior information compared to the other party, for example, a seller who knows better than the buyer. It occurs in the labour market as potential employees (sellers) have more knowledge about their own skills and ability to take on responsibilities than the employers (buyers) who are the potential buyers of their labour.
Employers can only ascertain the level of productivity of the employees after hiring them for a period of time. Furthermore, a number of employees may be slow in showing their full potential and level of productivity.
What are some of the attributes employers should focus on to gather details about the productivity of potential employees? How do potential employees communicate their potential levels of productivity to employers?
Michael Spence evolved a mathematical model that envisaged education as a signal of higher ability. Eventually, he received the Nobel Prize along with George Akerlof and Joseph Stiglitz in 2001 for his Spence Model and other associated work.
However, back in 1899, Thorstein Veblen, in his ‘The Theory of the Leisure Class: An Economic Study of Institutions’, argued that higher education symbolises membership in the leisure class. Conversely, Spence in 1973, contemplated that education can relay information about potential employees to potential employers.
Spence in his model hypothesised a labour market with two groups of employees, namely, high-productivity and low-productivity employees. In reality, if employers could differentiate the heterogeneous abilities of potential employees, then they would prefer to pay them as per their capabilities. Spence in his model assumed earlier that education has no influence on productivity.
This gives rise to the questions ‘Why do employees need to obtain higher education?’ and ‘Why do highly-educated employees receive higher salaries?’
Spence later contended that education can be a functional indication for a highly-productive group provided the ease of attaining the threshold level of education is positively correlated with productivity.
Thus, high-productivity employees would like to achieve higher credentials if the appropriate cost-benefit structure can formulate in contemplation to signal their probable employers.
The game theoretic equilibrium has resulted in highly-educated employees receiving higher salaries on the strong assumption that highly-productive employees are able to obtain the threshold degree at lower financial and opportunity costs than less productive employees. Spence articulated the fact that education is a valuable construct in the decision-making of potential employers and employees even though it might not necessarily reflect employees’ levels of productivity.
It is pertinent to confer the ‘sheepskin effect’ to this context, which manifests the link between wage hikes and higher credentials. This popular view empirically establishes the wage differential between dropouts and the accomplished even though their years of education might be identical.
Perhaps employers would find it more realistic to pay higher salaries to high-productivity employees as the prospect of additional income need not necessarily motivate low-productivity employees.
Flores and Light emphasised that individuals are considered homogeneous in terms of skills in the job market if they possess the same university degrees based on the assumption that high-productivity employees are able to acquire their degrees comparatively early. It is empirically evident that education is a statistically significant signal for salary determination along with other variables such as age, gender and geographical boundaries.
In a nutshell, education plays a varied role in society but accomplishment of a higher university degree within the stipulated time span is critical when entering the job market. Furthermore, education can be a key factor in potential employees obtaining higher salaries.
Tanusree Chakravarty Mukherjee is a lecturer in economics and finance at the School of Business at Curtin Sarawak.