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SIGNALING THEORY

Signaling theory is generally concerned with the reduction of information asymmetry between two market actors.11 Briefly, information asymmetry arises because "different people know different things"; that is, market actors inherently possess idiosyncratic stocks of information, and differences in those stocks give rise to information asymmetry. 12 Management scholars have eagerly adopted signaling theory as an effective mechanism to describe how firms communicate information (e.g., beliefs, competencies, and intentions) through specific behaviors that lend credence to the underlying informational value.13 For example, in his seminal work, Spence suggested that job market candidates pursue higher-education degrees to signal intellectual competency to prospective employers.14 Although the candidate might verbally express his or her intellectual abilities during an interview, possessing a college degree provides more tangible, behavioral evidence of intellectual competency to the prospective employer, thereby lowering information asymmetry.

Signaling theory posits that the signaler (the firm sending the signal) will engage in purposeful behavior to communicate information that reduces information asymmetry in a manner beneficial to the firm. For example, a start-up firm may add a high-profile executive to their board to signal managerial competency. However, signaling theory also applies to situations in which the signaler did not intend to engage in signaling behavior, but where the firm's actions had the net effect of reducing information asymmetry in a manner that may or may not have been positive for the firm. For example, Berkshire Hathaway's $3 billion investment in General Electric (GE) in 2008 signaled that GE's cash position was weaker than may have been previously thought, although the reputation of Berkshire's Warren Buffett also provided a vote of confidence in GE's long-term performance. Thus, whether purposeful or not, valuable information is embedded in the strategies, tactics, and behaviors pursued by all firms, and are subject to interpretation and parsing by other market actors to reduce information asymmetries.

A critical assumption underlying signaling theory is the notion of signal quality or "the underlying, unobservable ability of the signaler to fulfill the needs or demands of an outsider observing the signal."15 To illustrate, consider that firms vary in their abilities (e.g., managerial skills, core competencies, and resource exploitation) and that each firm possesses demonstrably superior understanding of its abilities than do exogenous market actors.16 Each firm that engages in signaling behaviors, whether intentional or not, is communicating information about its underlying abilities; firms with greater abilities, and therefore of higher quality, send correspondingly higher quality signals that are more likely to be noticed by other market actors.17 This begs the question, however, of how exogenous actors evaluate the quality of the signaler. Although a variety of proxies such as superior financial performance or market prestige exist, one such proxy particularly salient to the current discussion is organizational reputation.18

As Lange, Lee, and Dai note in their recent review of the literature on reputation, "organizational reputation is a simple idea with intuitive appeal."19 The "simple idea" is the notion that over time and through the engagement in consistent, purposeful behaviors, a generalized understanding forms in the minds of market actors as to the basic composition, philosophies, and operating DNA of a focal firm. Such a reputation, be it positive or pejorative, provides insight across a spectrum of organizational phenomenon (e.g., anticipating future behaviors, calculating how the firm might react to new competitive threats, assumptions of the quality of the firm's products, and the trustworthiness of its senior managers). In short, the reputation of the firm, particularly in light of inherent information asymmetries across market actors, can be construed as being representative of the perceived quality of the firm and thereby the perceived quality of the signals that the firm sends. When a firm engages in signaling behavior, signal recipients draw on aspects of the signaler's reputation to gauge the quality of the signal sent. Importantly, such reputational elements can manifest at the level of the signal itself and at the organizational level of the signaler.

I t should be noted that the issue of reputation does not necessarily mean that market actors overlook signals sent by firms of perceived lower quality per se. Rather, signal recipients will judge the content of such signals differentially, with greater weight paid to those signals sent by firms with reputational attributes that impart credibility to particular strategic or tactical behaviors. For example, Apple has a reputation for introducing innovative consumer technology products with appealing industrial designs. As such, market actors come to expect that Apple's future product introductions will be consistent with Apple's reputation and will thus be both innovative and aesthetically pleasing. Since the act of introducing a new product to the market represents a tangible strategic behavior, such an action is inherently a signaling behavior. Other market actors can draw information from such signals, particularly reputational mechanisms, to glean insights as to the intentions and beliefs of the innovator firm regarding current and anticipated market conditions. Such insights guide imitation decision making.

 
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