2.1 Problem of adverse selection

• What sort of workers does the firm want?

• How to encourage the right people to apply?

• How to select the right people from the applicants?

• How to promote people within an organization?

The firm does not know how good an applicant is. Wrong types of candidates may have an incentive to pose as right (adverse selection).

• each applicant, whether good or not, has an incentive to say she/he is good. The firm may end up hiring the least desirable workers (adverse selection).

Because the type of candidate is unobservable, the firm must make effort (screening) to detect the type from the information candidates choose to communicate about themselves (signaling)

Transactions between the firm and job applicants are costly —>there are efficiency gains from targeting the audiences in which the right people are more likely to be found.

Ways of targeting:

• Place the job ad in niche outlets or social networks united around a relevant topic (e.g., LinkedIn groups)

• Use co-worker referrals, possibly offering incentives for finding a good candidate

• Use personnel search organizations

Benefits:

• savings on search costs

• advantages from using better information about applicants possessed by their friends, group-mates, specialized employment agencies

• ready-made social connections (referrals)

• a third-party brokerage (via employment agency) in sensitive situations

Disadvantages:

• costs of referrals and intermediation

• danger of nepotism and lack of diversity in case of referrals

Important remark: Targeting typically increases the chance of finding the right person for the job from very small to small. Person-job fit can, and should be improved through selection-our next topic.

The problem of choice under incomplete information and conflict of interests

• The theories of adverse selection, signaling and screening help understand what´s going on in the selection process.

• The number applicants typically exceed the number of vacancies.

• Small problem: One doesn´t know for sure how good each applicant is for the advertised vacancy (incomplete information).

• Bigger problem: each applicant, whether good or not, has an incentive to say she/he is good. The firm may end up hiring the least desirable workers (adverse selection). —>Preventing adverse selection: applicants may choose to signal their ability, while the firm screens the applicants, trying to infer the unobserved ability from their observed characteristics.

• H and A could get hired by sending a signal to the firm about their type.

• The signal has to be costly and credible, in the sense that no worker should find it profitable to send a signal of the type other than his own.

In the new equilibrium…

• Separating equilibrium:

  different types send different signals by obtaining different education levels and receive different wages.

• Pooling equilibrium:

  different types obtain the same education and receive the same wage.

  
  

—>Pooling equilibrium can occur when reservation utilities differ less by worker than productivity.

• Unobservability of worker type creates incentives for all, including low-ability, workers to pretend to be high-ability.

• This is cheap talk for firms, unless backed by a credible signal: only profitable for types above certain ability level, unprofitable for the rest.

• Education is a favorite example. Other examples include social work, sports, international travel, etc., that is: activities that only certain types of people would be interested in doing —> by showing a record of such activities, workers can signal their type.

• However, signaling is inefficient. Recall the example in the lecture: education is more costly than the productivity gains it gives. So, if you think you're wasting time attending this lecture, you may be right, but think about the long-term...