Michael Waldman on market rationality and promotion signaling

Present Value, an independent editorial project produced and hosted by students in the Samuel Curtis Johnson Graduate School of Management, had the pleasure of interviewing Michael Waldman, the Charles H. Dyson Professor of Management and a professor of economics at Johnson.

Present Value can be streamed through the Present Value website or listened to through Apple Podcasts, Spotify, or wherever you get your podcasts.

The effects of rational players on markets

The theory of rational choice was a popular topic of discussion among Michael Waldman’s colleagues when he was an assistant professor at UCLA in the 1980s. If just some people behave in a rational way, the thinking went, won’t markets behave in a rational way as well?

He had been thinking about that question when he ran into a traffic jam on the 405, the main highway in Los Angeles, on the way to work. Sitting there in traffic, he saw the question framed in the context of the choices before him and the other drivers on the highway—to stay on the main route or find a detour.

From those musings, Waldman and his co-author, John Haltiwanger, developed a theory based on two scenarios known to game theorists, strategic substitutability and strategic complementarity, to think about the effects of rational players on markets.

In a market characterized by strategic substitutability, Waldman explains, when more people pursue an activity, the return to choosing that activity falls. The actions of just a few rational players will be enough to make the market appear rational even if the actions of some other players are not completely rational. This was the traffic example: if Waldman were to turn off the 405 and take a shortcut through side streets, thereby getting to work sooner, he would be making a rational choice. As more and more people took the same route, the return to choosing that shortcut would fall, and a point of rational equilibrium would eventually be reached.

In a market characterized by strategic complementarity, on the other hand, when more people choose an activity, the return to choosing that activity rises. Having just a few rational players won’t make the market fully rational, because rational players will tend to reinforce the mistakes of less rational players. An example of this in the real world can be seen in the selection between two different hardware standards, for example HDMI vs. DisplayPort. As more and more people choose a specific standard, there is a strategic complementarity effect due to the additional compatibility that users will gain. This market can quickly turn irrational, however, if enough individuals make the irrational choice, which would not be outweighed by rational actors due to reinforcement of the irrational choice. Waldman and Haltiwanger published their initial paper on the topic in 1985, and there is now an extensive literature in experimental economics validating their initial insight and showing how it manifests itself in various settings.

Promotion signaling

Prior to Waldman’s research, job promotions were seen only as a worker allocation mechanism, a means to improve the fit between a worker and a job. In a 1984 paper that grew out of his dissertation, Waldman, however, demonstrated that promotions not only allocate workers but also serve as a signal to the outside world of their productive value, which in turn allows them to command higher pay. This leads to a distortion in the promotion process, because an employer must weigh the cost of promoting a worker against the value of the additional productivity that can be expected to result from the more desirable job placement. Unless the worker can be expected to be much more productive in the new position, the employer may decide to forego the promotion.

Extending Waldman’s signaling concept to educational attainment, Dan Bernhardt theorized in 1995 that promoting an individual with a degree from a well-respected college or university leads to less promotion distortion than does promoting a graduate of a lesser institution. Promoting someone with an unremarkable education sends a stronger signal to others of that employee’s productivity, and therefore the salary increase that person merits, than does promoting a graduate of a top school, who is already assumed to be in a higher-ability group. By this reasoning, it costs less to promote the elite graduate, even if the other worker is somewhat more productive. A handful of subsequent studies have lent empirical support to this conclusion.

Waldman and a Johnson colleague, Thomas Jungbauer, are now examining another question related to education signaling, résumé padding and its effects on social welfare. Their work relaxes the standard assumption in education signaling models that a person’s educational qualifications are always publicly known and, therefore, that the education signal is always reliable. In job situations where a person with falsified credentials can be indistinguishable to employers from those with legitimate educational qualifications, the counterintuitive result is that résumé padding can actually improve welfare.  The standard argument in education signaling models is that there is overinvestment in education.  It is the signal itself—that the holder of a prestigious degree is more valuable in terms of both human capital and earnings potential—that leads to overinvestment in education. The more individuals embellish their achievements, the more the value of education’s promotion signal is diminished. Waldman and Jungbauer show that this weakening of the signal means that résumé padding potentially improves social welfare by reducing overinvestment in education.

Life lessons

In the final part of the interview, Waldman discusses a few of the life lessons he learned from his father, a concentration camp survivor: perseverance, how to think about taking risks, and being a good person.

Waldman expands on the above topics and others in his full-length Present Value episode. Listen, subscribe, and share!

About Michael Waldman

Michael Waldman is the Charles H. Dyson Professor of Management and a professor of economics at the Samuel Curtis Johnson Graduate School of Management in the Cornell SC Johnson College of Business. He is widely recognized as a top researcher in the fields of industrial organization, labor economics, and organizational economics. He joined Cornell’s faculty in 1991 and since that time has served both Johnson and the university in multiple capacities, including on the university’s 2011 Strategic Planning Advisory Council. He earned a BS in economics from MIT and a PhD in economics from the University of Pennsylvania.