Issues in personnel economics
Inferring a worker’s productivity
In theory, a firm should hire a worker only if the value of his
marginal product exceeds the pay he receives.
(Marginal benefit vs. marginal cost)
Ideally, the marginal product of each worker is known.
For example, if you believe that hiring Mr. Doe as a manager
will increase your profit by $50,000 a year, then $50,000 is
the maximum amount you should be paying him.
In most real-world cases, however, the future MP of a worker
is unknown.
Worker’s marginal product depends on his inherent
characteristics (talent, skills, physical strength, etc.)
and the effort he decides to put in the job.
All those variables are known to the worker but not to
the firm – an example of asymmetric information.
Keeping a worker who is not fit for the job is costly
even when it is done for a limited time.
If the firm wants to increase its chances of hiring the
right person, it can use remedies common to any
market with asymmetric information.
1. Screening – the uninformed party (the firm) does
something that gives it a better idea about the
future productivity of a worker.
This effort is usually costly.
(Keep in mind that future productivity cannot be
determined with certainty. We can only measure
some characteristic that we believe is correlated with
abilities.)
Form of screening
What is measured
Rationale
Personal interview
General impression of the
person; handling of
difficult questions, ethical
dilemmas, etc.
To determine how well the
person would fit into the
company culture
Drug testing
Whether the person used
drugs in the last two
weeks
Some people using drugs
are addicted therefore less
dependable
Criminal record
Whether the person …
well, has a criminal record
(and what kind of record)
There is a correlation
between the criminal
record and person’s
responsibility /
dependability
Recommendation
letters
What some other people
think about the applicant
Screening applicants is more justified when
•The degree of correlation between the measured
variable and the abilities is high.
•The cost of screening is low.
•A
large
portion of applicants will be refused
employment as a result.
•The spread in applicants’ abilities is large.
2. Signaling – the informed party does something
to signal their “type” to the uninformed party.
In the labor market, high-ability workers signal
their ability to the firm, thus distinguishing
themselves from low-ability individuals.
Examples:
•Credentials (extra lines on the resume)
•Education (CPA, Ph.D., bar exam, MBA,…)
As always, a signal has to be credible.
Therefore, it has to be hard for the other type(s) to mimic it.
The signal is more credible when:
Obtaining the credential is
easier
workers but
for low-ability workers.
more difficult
for high-ability
Also note that low-ability workers will try the harder to mimic
the signal of high ability the more worthwhile it is to do so.
Hence the signal is more credible when the difference in
pay between high- and low-ability workers is
small .
Education as a signal
Model developed by Spence (a 2001 Nobel laureate).
What do we learn in college? How relevant is the
knowledge gained in college for our future career?
If it is, then why do many firms, upon hiring college
graduates, send them to some sort of job-specific training?
What if a college degree (or our GPA) is nothing more than
a signal of our abilities or our commitment to hard work?
Let us take this hypothesis to an extreme and assume
(for the purpose of this model) that college, or any other
form of education does not affect our innate abilities.
Instead, it is sort of a tryout.
Let’s say there are two different types of individuals in the
economy, those of high ability and those of low ability.
Once hired, they are capable of producing different
marginal product, the high-ability types being more
productive.
Each worker is paid the value of his marginal product.
Each worker knows his own type, but the firms don’t
(hence we are dealing with asymmetric information).
IF firms HAD perfect information, they would pay each
type what that type deserves, wH and wL, respectively.
wH > wL
Since firms cannot distinguish between high and low
type workers, they pay everyone the same wage, equal
to the expected value of the marginal product.
Let us assume that the shares of the two types in the
population are equal, αH = αL= 0.5.
Then the average wage, equal to the expected value of
the marginal product, is
wAV = αH · wH + αL · wL = (wH + wL)/2.
Because of incomplete information, high type workers
are underpaid while low type are overpaid.
Now, suppose anyone can signal his ability by getting
a college degree (or another form of education).
Education is obtained at a cost.
(This cost is not necessarily monetary – it can be
expressed in the time spent and the amount of misery
a person has to go through to get a degree.)
This cost is different for the two types, cH < cL.
Low type
Get education
High Get
type educ.
No
wH  wL
wH  wL
 cH
 cL
,
2
2
wL , wH  c L
No
wH  c H ,
wL
wH  wL wH  wL
,
2
2
The selection of an equilibrium depends on model parameters.
Example 1.
wH = 400
cH = 60
wL = 200
cL = 120
Low type
Get education
High Get
type educ.
No
(wH > wL)
(cH < cL)
No
240 , 180
340 , 200
200 , 280
300 , 300
Example 1.
wH = 400
cH = 60
wL = 200
cL = 120
Low type
Get education
High Get
type educ.
No
(wH > wL)
(cH < cL)
No
240 , 180
340 , 200
200 , 280
300 , 300
Under these parameters, everything works as it should –
High ability individuals get education and get recognized as high ability;
Low-ability don’t
Example 2.
wH = 400
wL = 200
cH = 40
cL = 60
(getting education gets easier)
Low type
Get education
High Get
type educ.
No
(wH > wL)
(cH < cL)
No
260 , 240
360 , 200
200 , 340
300 , 300
Example 2.
wH = 400
wL = 200
cH = 40
cL = 60
(getting education gets easier)
Low type
Get education
High Get
type educ.
No
(wH > wL)
(cH < cL)
No
260 , 240
360 , 200
200 , 340
300 , 300
Both types choose to get education.
Education is no longer a signal of abilities.
Formal definitions of the two types of equilibria:
Separating equilibrium – a situation when it is possible
to differentiate between the two types of people (or
products, as in the lemons model). – see Example 1.
Pooling equilibrium – different types behave alike and
are therefore treated alike, as in Example 2.
It is possible to show that,
• If wH - wL > 2 cL, then both types get education.
A pooling equilibrium occurs.
– Ex.2
• If 2 cL > wH - wL > 2 cH, then all high-ability
individuals choose to get a degree, thus
separating themselves from low-ability types. – Ex.1
A separating equilibrium occurs.
• If 2 cH > wH - wL > cH, then either of the two equilibria
may occur.
• If wH - wL < cH, then none of the types chooses to get a
degree. Another pooling equilibrium.
cH
2cH
2cL
wH – wL :
Which type gets degree:
none
none or
H only
H only
both
Type of equilibrium:
Pooling
Pooling or
separating
Separating
Pooling
Separating equilibrium leads to higher efficiency (think
of an analogy with the lemons model).
In order for education to serve as a signal, the cost of
getting it has to be neither too high nor too low.
This model raises several interesting issues.
•What happens as getting a degree gets easier?
(See example 2 above.)
•Top schools and “regular” schools: In which case a
degree is a more credible signal? Why?