Market signaling with grades

We consider a market signaling model in which receivers observe both the sender’s costly signal as well as a stochastic grade that is correlated with the sender’s type. In equilibrium, the sender resolves the trade-off between using the costly signal versus relying on the noisy grade to distinguish himself. When grades are sufficiently informative, separating equilibria do not survive common refinements. The prediction depends on the prior—it involves full pooling when the prior puts sufficient weight on the high type and partial pooling otherwise. The equilibrium converges to the full-information outcome as the fraction of high types goes to one—resolving a long-standing paradox within the signaling literature. JEL Classification: D82, D83, D41, C72