2.1 You must decide whether to hire another secretary, whose output is easily measured, or merely to
install Voice Processor, which is a new and extremely reliable voice recognition software, and employ
existing secretaries. A secretary costs $800 per month and Voice Processor, which can only be rented,
costs $500 per month. Voice Processor yields 6,000 pages of output per year. The firm is only planning
to be in business for one more year.
a. If a new secretary produces twice as much output (correctly typed pages) as Voice Processor, should
the firm hire the secretary or rent Voice Processor?
b. Now suppose that half of the secretaries are twice as productive as Voice Processor, but the other half
are only equally productive. Productivity can be ascertained only after a four-month period. Neither
firms nor secretaries know the productivity before work occurs. What should the firm do now?
c. At how many months of required observation time is the firm indifferent between a secretary and a
Voice Processor?
Answer
a. Hire a secretary if the output/dollar from the secretary exceeds the output/dollar from the word
processor, or if 12,000/(800 x 12) > 6,000/(500 x 12)

1.25 > 1. It is, so hire the secretary.
b, c. If there were no probation phase, the Voice Processor would dominate clearly. Expected output for
secretary would be 9,000. Output/$ =1.5.
With probation: Expected Output for secretary: (500 x 4 months)/2 + 12,000/2 = 7,000, which has to be
compared to the costs for (4+12 months) … [(4+12) x 800]/2 = 6,400. ==> output/$ =1.09
3.1 Each time that a new worker must be hired, it costs the firm $10,000. Suppose that a worker produces $50,000 of
revenue if he works for his entire lifetime of 10 years. Some workers plan to leave the labor force before retirement
age after only 8 years, while others expect to stay on. But all applicants claim that they will not resign before
retirement.
There exist three firms in the economy: Firm 1 pays salary of $3,000 per year and a pension of $10,000 if the worker
works until normal retirement age. Firm 2 pays $3,300 per year worked and offers no pension. Firm 3 pays $3,300 per
year plus a pension of $8,000 to workers who remain until normal retirement age.
a. Which firm do early quitters choose?
b. Which firm do those who will stay to normal retirement choose?
c. Which firm has the highest profits?
d. What does (c) imply about the distribution of firms in the long run?
e. If all unprofitable firms leave the industry, how do workers distribute themselves across jobs?
f. Can firm 2 continue to pay according to the stated formula in the long run?
Answer
Earnings
Quitters
Stayers
Firm 1
$24,000
$40,000
Firm 2
26,400
33,000
Firm 3
26,400
41,000
a. Either 2 or 3, where earnings are $26,400.
b. Firm 3, with earnings of $41,000.
c. Firm 1 is able to hire no one so its profit is zero. Firm 2 gets only early quitters, and earns 40,000 –
10,000 – 26,400 = $3,600 per worker. Firm 3 gets both types, and earns $3,600 per quitter, but loses
$1,000 on each stayer. It would be better to organize as a type 2 firm.
d. No firm 3 in the long run.
e. Without firm 3, stayers go to firm 1, leavers to firm 2.
f. No. Firm 2 makes profit. Another firm 2 can steal workers away. Thus, wages are bid up to $3,750
per year since 8 x
3,750 = 30,000 and they get 40,000 – 10,000 = 30,000 on each.
3.2 Your firm is conducting a search for a chemical engineer with 5 to 10 years of experience. Thirty-two engineers
applied for the position. Preliminary screening of resumes revealed that twelve applicants appear to be qualified. All
of these candidates reside out of state. Mr. Thrifty, a hiring committee member, suggested that the firm could
economize on hiring costs by requiring that qualified applicants travel for an interview at their own expense. Mr.
Halfway suggested that it will make sense to promise that the applicants who will be denied the job will be reimbursed
for travel expenses, while the person who is offered the job will not receive reimbursement for his travel.
Which of the following statements most accurately describe your position:
a. Going along with Mr. Thrifty’s suggestion is strictly superior to selecting at random who among the twelve finalists
will be interviewed.
b. Going along with Mr. Thrifty’s suggestion may be costly, because the individuals who will come to an interview at
their own expense will be in the position to demand much higher wages than they could demand when their trip is paid
for by the company.
c. Both Thrifty's and Halfway's screening mechanisms may cause adverse selection.
Answer
c. Individuals who will come to an interview at their own expense will be, if anything, in a weaker
position for negotiating compensation. Indeed, by agreeing to go to an interview at his own expense a
prospective employee reveals that his surplus from the job is high. Thus, B is wrong. By making
applicants pay travel expenses associated with going to an interview, a firm will attract workers who
have difficulties in getting interviews and job offers; these individuals are likely to be less productive
than an average qualified applicant. Thus, the least able group may self-select.
4.3 Screening new workers is an expensive process. It is not unusual for costs involved in hiring a
professional to reach as much as 50% of her annual salary. By increasing the time and resources
involved in interviewing a prospective candidate, a firm can get a more accurate signal regarding her
ability. Which of the following are likely to result in increased expenditures on screening each
prospective employee?
I. A new government regulation that makes it more difficult to fire workers
II. An industry-wide wage increase
III. An increase in the rental cost of capital employed by a firm
a. I
b. I and II
c. I and III
d. II and III
Answer
c. When the expense associated with terminating an employee increases, the cost of a hiring mistake
increases, and thus more screening prior to hiring is desirable. The greater the capital cost the greater is
the cost of a hiring mistake. Indeed suppose, for the sake of argument, that there are only two types of
workers. Energetic and lazy, energetic type produces one unit per period while the lazy type produces
nothing. When an individual of the lazy type is hired the loss is equal to the wage of this individual plus
the rental cost of capital that this individual was using on the job. Consequently, the greater the cost of
capital the more costly is a hiring mistake.
4.4 Widget Services Inc. is a high-turnover, low-wage employer of unskilled labor. Most workers who join Widget do
not plan to stay with the firm for more than a few months. Traditionally the only screening mechanism employed by
Widget was a five-minute telephone interview. Typically Widget receives ten to twenty applications for a job opening.
The new human resources VP, Mr. Screening, feels that five-minute phone interviews do not give adequate
information for selecting among over 10 applicants. He argues that Widget is turning down a lot of good applicants
and occasionally hires really bad ones. He argues that the wages offered by widget are adequate and do not need to be
changed. However, he wants to abandon the phone interviews in favor of one-day on-site interviews. Assume that
prospective applicants have no private information about their ability and value to Widget. As a result of Mr.
Screening’s plan:
I. The number of applicants will decrease
II. The quality of an average applicant will not decrease
III. The quality of new hires will increase as a result of more screening
Which of the statements is correct?
a. I
b. I and II
c. I and III
e. I, II and III
Answer
b. The greater is the amount of time needed to apply the fewer people will apply; note that this is true
even if all workers are identical. In this example, workers cannot self-select because they do not have
any private information about ability. In general, more screening, if anything, tends to result in an
increase in the ability of an average applicant. As a result of more screening a firm can make a better
choice among those who applied. However, it has fewer applicants, thus the average quality of a new
hire may either increase or decrease.