Final answer:
True, signals can prevent adverse selection as long as a false signal is too costly to the person sending it. Signals, like warranties or educational degrees, help differentiate high-quality or low-risk individuals from others. Price can also be a signal, although inflation can complicate the perception of price as a quality indicator.
Step-by-step explanation:
Signals can indeed help prevent adverse selection as long as emitting a false signal is too costly for the sender.
The concept of adverse selection arises when there is a situation of asymmetric information, particularly in scenarios like insurance markets where buyers possess more information about their risk levels than sellers.
High-risk individuals might be inclined to purchase more insurance without disclosing their potential risk to the insurer, leading to adverse selection. A costly signal ensures that only those who genuinely possess the attributes implied by the signal can afford to send it, creating a separation between high-risk and low-risk consumers.
For instance, in areas like the used car market, certifications or warranties can serve as signals of quality because they represent a cost to the seller. Sellers of high-quality products are more likely to offer such signals, as the potential costs of warranty claims are lower for them than for sellers of low-quality products.
Similarly, in the job market, diplomas or certifications can act as signals of the competencies of a job applicant, as obtaining these qualifications is costly in terms of time and resources.
Price itself can also be a signal of quality.
Consumers often infer that higher-priced items, such as gemstones, cars, or legal services, are of better quality.
However, this can be misleading during periods of inflation, as rising prices may not necessarily reflect increased quality but rather the reduced purchasing power of money.