Abstract

A good type can separate itself from a bad type by giving a costly signal; the bad type will not mimic because the signal is costlier for the bad type. A good type can also separate itself from a bad type by attracting scrutiny; the bad type will not mimic because the bad type will not risk attracting scrutiny and being discovered. The contribution of this paper is to develop a simple model to find out which separation method will be used in the context of a firm signaling its value to a capital market. We then test the predictions of the model – costless signaling is more likely to be used by more ignored and more undervalued firms – using a data set that contains firms that employ costless signals (25 % of firms that announce open market share repurchases do not do it) and firms that employ costly signals (75 % of firms that announce open market share repurchases do it). The evidence in favor of the predictions of the model is surprisingly robust. COSTLESS VERSUS COSTLY SIGNALING IN CAPITAL MARKETS: THEORY AND EVIDENCE Imagine that you are a good type. The world does not know that you are a good type, and so it has pooled you with all the other types. Instead of being rated good, you are now being rated average. This is frustrating. So you try to convince the world that you are a good type. Ironically, this makes the world

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