Refinement of Signaling Theory in Labor Markets: Informational Frictions, Educational Overinvestment, and Equilibrium Fragility

This paper develops a dynamic signaling framework to analyze how educational investment evolves under imperfect information and how the informational value of credentials changes over time. It addresses a central question: under what conditions do signaling equilibria become fragile, and how does this fragility generate educational overinvestment and credential inflation in equilibrium? The model features heterogeneous productivity groups and endogenous educational choices, in which education plays both a signaling and a productive role. Informational frictions and wage-setting mechanisms jointly determine equilibrium configurations, allowing for separation, pooling, and mixed equilibria. The analysis shows that separating equilibria are inherently fragile: when signaling costs decline or when the share of lower-productivity workers becomes sufficiently small, incentives for imitation intensify, progressively eroding informational differentiation. This fragility gives rise to a cascade mechanism of overinvestment, whereby individuals increase educational attainment beyond efficient levels to preserve relative positioning. As a result, signaling distortions propagate across educational levels, generating persistent credential inflation and weakening the informational content of degrees. The framework also identifies conditions under which mixed equilibria may dominate separating equilibria in terms of aggregate welfare, particularly when the proportion of low-productivity workers is limited. By incorporating a productive dimension of education, the model distinguishes between pure signaling rents and genuine productivity gains, providing a unified interpretation of overeducation, declining returns to credentials, and persistent wage dispersion. Finally, the analysis characterizes an optimal taxation scheme that eliminates inefficient signaling rents while preserving incentives for productivity-enhancing investment. Taken together, the results highlight how equilibrium fragility, informational distortions, and strategic educational measures provide a unified explanation for diploma inflation, equilibrium segmentation, and persistent deviations from socially optimal investment levels.