Signalling, rationality and blunt levers

What trouble it causes in life when you can't just act directly on your preferences but need to signal indirectly.

Chief example at the moment: tomorrow's vote at Marks and Spencer. The shareholders don't really want to get rid of Stuart Rose - he's done a good job - but they do want to tell the M&S directors to stop messing around with corporate governance. So there's a proposal to get him to step down as chairman (not chief executive); but if it passes, or gets significant votes, it's likely to be interpreted as a vote of no confidence in Rose himself.

What else? A debate over on Worthwhile Canadian Initiative about the bluntness of the interest rate tool as a way of controlling inflation. If inflation is low anyway, for other reasons, but interest rates are kept low to boost economic activity, price pressures can leak over into asset prices - causing a house price bubble for example. A tool, when not designed directly to address the problem it is meant to address, has unintended consequences.

Commerce is full of these effects. Signalling is a common technique used by companies (sometimes without being fully aware of it) to influence customers' perceptions. For example a firm might spend more money than it needs to on advertising, fancy literature, business cards or office decor in order to demonstrate that it is a market-leading firm and worth trusting with your money. Banks and their marble lobbies are a classic example - the sunk cost is supposed to make you feel the executives are less likely to run off with your money. But that just led to prices that customers didn't want to pay - and ultimately to competition from online providers and non-banks.

Nowadays you're more likely to see this behaviour from large law firms or accountants: signalling quality by extra spending on offices or sponsorship of sporting events. The problem is that while it does signal high status, it also signals to savvy customers that their money is being wasted. The additional expense of these signals are borne either by the customer through fees, or by the shareholders through profit margins. Either way the firm becomes less competitive. Firms presumably judge the net effect to be positive - the benefits of the signals outweigh the drawbacks - and they might be - but is that an objective judgement? Or do the executives just enjoy the perks and trappings?

Other examples? Please suggest them and I'll update.

Companies and regulators then have two jobs to do. One is to continue to design better levers - so that they can signal quality without wasting money, or control inflation without creating asset bubbles, or get a new chairman without losing their chief executive.

The other is harder, and that is to understand psychology better. At one extreme we can encourage a new attitude of directness. Instead of influencing one thing in order to indirectly achieve another, just do the thing you want to do and be honest to people. If a firm needs to signal that it can afford to spend lots of money, it can just give a parcel of cash back to the client!

At the other extreme we can develop better models of how customers, shareholders or investors make decisions, and then construct a set of interventions which directly act on the relevant factors. This for example is at the heart of my behavioural risk regulation proposal: instead of using universal blunt price signals like interest rates, act directly by providing information to the investors who are unknowingly taking additional risks.

This latter aspect requires the development of much more subtle and personalised cognitive models than those we have now, but if achieved, there will be a transformation both in the successful management of the economy and in consumer welfare.