A great deal of advertising appears to convey no direct credible information about product qualities. Nevertheless, such advertising may indirectly signal quality if there exist market mechanisms that produce a positive relationship between product quality and advertising expenditures. Two models of this phenomenon are presented. In each, advertising signals quality in the short run. The models differ in their treatment of the effect of advertising on long-run sales. In the first, all high-quality firms ultimately establish reputations for high quality whether they advertise or not. This is shown to imply that advertising can signal quality if and only if high-quality production requires investments in specialized assets that increase fixed costs but not marginal costs. In the second model, where nonadvertising firms never acquire a reputation for high quality, advertising might signal quality even if marginal production costs are somewhat lower for low quality. These conclusions closely parallel arguments previously made by Phillip Nelson.

We construct a theory of competitive equilibrium under uncertainty using an entrepreneurial model with historical roots in the work of Knight in the 1920s. Individuals possess labor which they can supply as workers to a competitive labor market or use as entrepreneurs in running a firm. All entrepreneurs have access to the same risky technology and receive all profits from their firms. In the equilibrium, more risk averse individuals become workers while the less risk averse become entrepreneurs. Less risk averse entrepreneurs run larger firms and economy-wide increases in risk aversion reduce the equilibrium wage. A dynamic process of firm entry and exit is stable. The equilibrium is efficient only if all entrepreneurs are risk neutral. Inefficiencies in the number of firms and in the allocation of labor to firms are traced to inefficiencies in the risk allocation caused by institutional constraints on risk trading. In a second best sense which accounts for these constraints, the equilibrium is efficient.