In its simplest form, a signaling game has two players, one of which
has better information than the other and it is the player with the better
information that makes the first move. For example, Cachon and Lariviere
(2001) consider a model with one supplier and one manufacturer.
The supplier must build capacity for a key component to the manufacturer’s
product, but the manufacturer has a better demand forecast than
the supplier. In an ideal world the manufacturer would truthfully share
her demand forecast with the supplier so that the supplier could build
the appropriate amount of capacity. However, the manufacturer always
benefits from a larger installed capacity in case demand turns out to be
high but it is the supplier that bears the cost of that capacity. Hence,
the manufacturer has an incentive to inflate her forecast to the supplier.
The manufacturer’s hope is that the supplier actually believes the rosy
forecast and builds additional capacity. Unfortunately, the supplier is
aware of this incentive to distort the forecast, and therefore should view
the manufacturer’s forecast with skepticism. The key issue is whether
there is something the manufacturer should do to make her forecast convincing,
i.e., credible