Signaling and Imperfect Capital Markets

This paper uses a two-period signaling model of education to show that capital-market imperfections can cause underinvestment in the signal. This can happen even if the government pays all tuition bills and access to credit increases with education. To allow loan availability to grow with education, a model of imperfect capital markets is derived from an economic environment that will not support perfect capital markets. This model complements other papers on credit rationing by introducing signaling by borrowers. An auxiliary result of the paper is that improving students’ access to credit can achieve a Pareto-improvement, even if it causes overinvestment in education.