Signaling Theory: A Review and Asse

Signaling Theory: A Review and Assessment
Brian L. Connelly
Auburn University
S. Trevis Certo
Arizona State University
R. Duane Ireland
Texas A&M University
Christopher R. Reutzel
Utah State University
Signaling theory is useful for describing behavior when two parties (individuals or organizations)
have access to different information. Typically, one party, the sender, must choose
whether and how to communicate (or signal) that information, and the other party, the receiver,
must choose how to interpret the signal. Accordingly, signaling theory holds a prominent position
in a variety of management literatures, including strategic management, entrepreneurship,
and human resource management. While the use of signaling theory has gained momentum in
recent years, its central tenets have become blurred as it has been applied to organizational
concerns. The authors, therefore, provide a concise synthesis of the theory and its key concepts,
review its use in the management literature, and put forward directions for future research that
will encourage scholars to use signaling theory in new ways and to develop more complex
formulations and nuanced variations of the theory.
Keywords: signal; signaling theory; information asymmetry; literature review
39
Acknowledgments: This research was conducted, in part, under the sponsorship of Auburn University’s Lowder
Center for Family Business and Entrepreneurship. In addition, we gratefully acknowledge the guidance and direction
of the editor, Steven Michael, and two anonymous reviewers whose guidance considerably improved our
review.
Corresponding author: Brian L. Connelly, Auburn University, 415 West Magnolia Avenue, Auburn, AL 36849, USA
Email: bconnelly@auburn.edu
Journal of Management
Vol. 37 No. 1, January 2011 39-67
DOI: 10.1177/0149206310388419
© The Author(s) 2011
Reprints and permission: http://www.
sagepub.com/journalsPermissions.nav
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40 Journal of Management / January 2011
When top executives increase ownership stakes in their firms, they communicate to capital
markets that diversification strategies are in the owners’ best interests (Goranova, Alessandri,
Brandes, & Dharwadkar, 2007). A college football coach visits area high schools in a
HummerTM limousine emblazoned with the school’s logo to denote a resource-rich environment
to prospective recruits (Turban & Cable, 2003). Leaders of a young firm in an initial
public offering (IPO) stack their board with a diverse group of prestigious directors to send
a message to potential investors about the firm’s legitimacy (Certo, 2003; Filatotchev &
Bishop, 2002). Each of these examples illustrates how one party may undertake actions to
signal its underlying quality to other parties.
Signaling theory is fundamentally concerned with reducing information asymmetry between
two parties (Spence, 2002). For example, Spence’s (1973) seminal work on labor markets
demonstrated how a job applicant might engage in behaviors to reduce information asymmetry
that hampers the selection ability of prospective employers. Spence illustrated how
high-quality prospective employees distinguish themselves from low-quality prospects via
the costly signal of rigorous higher education. This work triggered an enormous volume of
literature applying signaling theory to selection scenarios that occur in a range of disciplines
from anthropology to zoology (Bird & Smith, 2005).
Management scholars have also applied signaling theory to help explain the influence of
information asymmetry in a wide array of research contexts. A recent study of corporate governance,
for example, shows how CEOs signal the unobservable quality of their firms to potential
investors via the observable quality of their financial statements (Zhang & Wiersema, 2009).
Diversity researchers use signaling theory to explain how firms use heterogeneous boards to
communicate adherence to social values to a range of organizational stakeholders (Miller &
Triana, 2009). Signaling theory is frequently used in the entrepreneurship literature, where
scholars have examined the signaling value of board characteristics (Certo, 2003), top management
team (TMT) characteristics (Lester, Certo, Dalton, Dalton, & Cannella, 2006), venture
capitalist and angel investor presence (Elitzur & Gavius, 2003), and founder involvement
(Busenitz, Fiet, & Moesel, 2005). Signaling theory is also important to human resource management,
where a number of studies have examined signaling that occurs during the recruitment
process (Suazo, Martínez, & Sandoval, 2009). As illustrated in Figure 1, the use of signaling
theory has gained momentum in the management literature in recent years as scholars have
expanded the range of potential signals and the contexts in which signaling occurs.
Despite the emergence of signaling theory in management research, as of yet there exists
no concise review in the management literature. As a result, management scholars almost
universally refer to either Spence’s (1973) examination of signaling in job markets or Ross’s
(1977) study of managerial incentives as signals to describe the theory’s central tenets. Over
time, however, the key concepts underlying signaling theory have become blurred (Highhouse,
Thornbury, & Little, 2007), causing some to argue that signaling theory is ill defined (Ehrhart
& Ziegert, 2005). Although a number of studies integrate signaling concepts with related management
theories (e.g., Deephouse, 2000; Ryan, Sacco, McFarland, & Kriska, 2000; Sanders
& Boivie, 2004), no existing management research has systematically described the core
ideas of signaling theory and how management scholars have applied them. We address this
gap in the literature by reviewing management research relying on signaling theory.
Our review offers several intended contributions to management research involving signaling
theory. First, we collect and synthesize signaling theory’s key constructs. This includes
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Connelly et al. / Signaling Theory 41
describing the important role of information asymmetry in the signaling process and reviewing
key studies in economics to explicate core signaling concepts. We are hopeful this section
will provide an extra measure of clarity to the literature, as our review revealed that research
in management utilizing signaling theory is laden with inconsistent terminology. We then
consider how management scholars have used the theory to study and explain organizational
phenomena. We examined key studies dealing with these issues from leading management
journals, including the Academy of Management Journal, Academy of Management Review,
Journal of Management, Journal of Management Studies, Strategic Management Journal, Journal
of Business Venturing, Entrepreneurship Theory and Practice, Journal of Applied Psychology,
and Personnel Psychology. This section, we hope, will help unify and integrate the diverse
ways in which management researchers have applied signaling theory to organizational concerns.
Lastly, we extend the discussion of signaling theory in the literature by highlighting
and developing a number of potential avenues for future management research. We are hopeful
the ideas we put forth encourage scholars to use signaling theory in new ways and to
develop more complex formulations and nuanced variations of the theory.
Information Asymmetry and Signaling Theory
Information Asymmetry
Information affects the decision-making processes used by individuals in households, businesses,
and governments. Individuals make decisions based on public information, which is freely
Figure 1
Management Publications That Cite Signaling or Signaling Theory, 1989-2009
0
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120
140
160
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Number of Citations
Publication Year
Note: The search terms included the British variant signalling theory.
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42 Journal of Management / January 2011
available, and private information, which is available to only a subset of the public. Stiglitz
(2002: 469) explained that information asymmetries occur when “different people know different
things.” Because some information is private, information asymmetries arise between
those who hold that information and those who could potentially make better decisions if
they had it.
For more than a century, formal economic models of decision-making processes were
based on the assumption of perfect information, where such information asymmetries are
ignored (Stiglitz, 2002). Despite the well-known imperfections of information, economists
had largely assumed that markets with minor information imperfections would behave substantively
the same as markets with perfect information (Stiglitz, 2000). A number of scholars
have devoted their careers to understanding the extent to which imperfect information
influences decision making in the marketplace. In fact, George Akerlof, Michael Spence,
and Joseph Stiglitz received the 2001 Nobel Prize in Economics for their work in information
economics. Advances in this regard appear to reveal the limited utility of many traditional
economic models but also provide insights regarding phenomena that traditional models do not
consider (Stiglitz, 1985).
Stiglitz (2000) highlights two broad types of information where asymmetry is particularly
important: information about quality and information about intent. In the first case, information
asymmetry is important when one party is not fully aware of the characteristics of
another party. In the second case, information asymmetry also is important when one party
is concerned about another party’s behavior or behavioral intentions (Elitzur & Gavious,
2003). Much of the research on information asymmet