A Signal Works When It Costs the Wrong Side More.

What he was looking at

Michael Spence was a Harvard graduate student when an adviser told him to read Akerlof’s “Lemons.” He remembered it as “quite electrifying.” His 1972 thesis became this paper.

His market was hiring. An employer can’t see how productive an applicant will be until long after the decision. As he put it:

“To hire someone, then, is frequently to purchase a lottery.” Spence (1973), p. 356

What the employer can see is the applicant’s education, which is visible and costly to get.

What he found

Education can sort applicants even if it teaches them nothing, as long as one condition holds:

“a signal will not effectively distinguish one applicant from another, unless the costs of signaling are negatively correlated with productive capability” p. 358

In plain terms: the signal has to be cheaper for the better applicants. If a degree takes less effort for the people who’ll be good at the job, they’re the ones who get it, and the degree becomes a reliable sign of who’s good. In his worked example, the degree does nothing for the work itself:

“It is productive for the individual, but, in this example, it does not increase his real marginal product at all.” p. 364

He was candid about the cost. In the example, “everyone would prefer a situation in which there is no signaling” (p. 364). And more generally: “Systematic overinvestment in education is a distinct possibility” (p. 368).

Spence shared the 2001 Nobel prize with Akerlof and Stiglitz. In his Nobel lecture he recalls a journalist asking whether you could win the prize for simply noticing that some people in a market know things others don’t. “I thought it was pretty funny,” he said.

What it means

A signal is information created by a cost that differs by type. It doesn’t have to make anyone better. It has to be easier for the better side to send, so that sending it sorts.

That also tells you when a signal fails: when it costs everyone about the same. Then the low-value side sends it too, and it sorts nobody.

Where it shows up in a revenue team

• A call instead of a web form, a booked appraisal, a data upload, a paid pilot. Each one means something only if it costs a poor-fit prospect more than a good-fit one.
• Friction that costs everyone the same is just friction. It lowers volume without changing the mix.
• You can design signals. Most of the data that predicts value isn’t in your systems yet. Picking the step or question that the right customers will take and the wrong ones won’t is the craft.