An alternative method is to offer guarantees or warranties. A warranty
serves two related purposes. First, it protects customers against quality prob-
lems or defects in the products. Second, the warranty offer itself signals prod-
uct quality. A producer of a high-quality product can afford to offer an
extensive warranty because guaranteeing a reliable product will cost the pro-
ducer very little. A producer of a low-quality product will choose not to offer
such a warranty because it is much more expensive for it to do so. In short, the
offer of a warranty provides a (low-cost) way for high-quality producers to dis-
tinguish themselves from low-quality producers. Signaling quality in this way
allows high-quality producers to charge higher prices for their goods and serv-
ices. Of course, warranties may not always produce the desired result. In 2002
Amtrak withdrew a warranty whereby dissatisfied customers were entitled to
free future train travel. Amtrak found itself issuing more and more free travel
for situations that it could not control, including weather delays and delays due
to having to cede priority to freight trains.^4
Signalingis a common response to the presence of asymmetric informa-
tion. A particularly important example occurs in job markets. At the time of hir-
ing, a firm may find it difficult to predict how productive different job
candidates will be. Certainly, management will have much better information
after the worker has been on the job for six months or a year, but by that time,
management may have invested considerable resources in on-the-job training
for the worker and may have little flexibility in modifying its decisions.
(Terminating unproductive workers is difficult and costly.)
If the firm cannot distinguish between high- and low-quality workers at the
time of hiring, the best it can do is offer the same wage (based on average pro-
ductivity) to all new workers. (Low-quality workers are paid more than their
worth and high-quality workers less than their worth.) But the workers them-
selves are well aware of their abilities, skills, and energy. High-productivity work-
ers would like to signal their true abilities to potential employers and thereby
obtain higher-paying jobs. One way to signal their true value is via education.^5
Thus, education not only provides knowledge—ways of thinking as well as
specific skills—that can increase an individual’s productivity, it also serves as a
signal. Even if it did not contribute to productivity, education would continue to
signalproductivity. Individuals of high innate ability find school easier and per-
form better. Thus productive persons have greater benefits and lower costs from
additional years of education and will invest more heavily in education than will
their less productive counterparts. Other things being equal, the higher an indi-
vidual’s educational achievement (measured by years of schooling, advanced
degrees, and so on), then the greater is his or her potential productivity. In short,586 Chapter 14 Asymmetric Information and Organizational Design(^4) See B. Mohl, “Amtrak Satisfaction Guarantee Was Doomed from the Outset,” Boston Sunday Globe,
November 3, 2002, p. M8.
(^5) The classic treatment of this topic is A. M. Spence, Market Signaling(Cambridge, MA: Harvard
University Press, 1974). Professors Spence and Ackerlof (see footnote 2) shared the 2001 Nobel
Prize in economics (with J. Stiglitz) for the cited research in asymmetric information.
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