EC 202 Lecture Notes 19 - Hidden Characteristics

Hidden Characteristics: Screening

Asymmetric information arises when one party in a transaction possesses more information than the other. In situations involving asymmetric information due to hidden characteristics, the uninformed party may be able to infer the informed party's type by offering options that appeal differently based on their type. This principle mirrors second-degree price discrimination.

Screening

Wages often increase with seniority. This could be attributed to workers becoming more productive with experience, but asymetric information also plays a role. In the labor market, job applicants are more informed about their own characteristics than employers.

Screening: An Example

A firm hires a worker for two periods. Training costs $T$ are incurred once at the start. A trained worker adds a net value $V$ to the firm each period, where V < T < 2V. Untrained workers contribute 0. A worker can always earn a wage $w_0$ in another job.

There are two types of workers:

• L-type: content to work at the same firm for both periods.

• S-type: incur a psychological cost $C$ for staying at the same firm for more than one period.

Assume T + C > 2V. The firm won't compensate an S-type to stay two periods. Also, T > V, so the firm loses money hiring an S-type. But T < 2V, so it's worthwhile to hire an L-type.

The firm can offer short-term (wage for each period) or long-term contracts (wage for both periods, $w<em>1$ and $w</em>2$). If short-term contracts with $w<em>1 ≥ w</em>0$ and $w<em>2 ≥ w</em>0$ are offered, both worker types are attracted. The firm profits from L-types but loses money on S-types.

The firm can offer only long-term contracts. Any contract with $w<em>1 + w</em>2 ≥ 2w<em>0$ attracts L-types, and any contract with w1 < w0 does not attract S-types. Setting w1 < w0 and w2 > w0 such that $w</em>1 + w<em>2 = 2w</em>0$ allows the firm to hire only L-types without overpaying them. In this contract, $w$ rises with seniority.

Signalling

Signalling is when an informed party tries to differentiate itself from another informed party in the eyes of an uninformed party.

People go to university to obtain better jobs because education is viewed as building useful skills (human capital). However, another view exists.

Education as a Signal

Education provides job seekers with an advantage over non-graduates and signals general qualities like intelligence and diligence. Recruiters use degrees to screen applicants, locking non-graduates out of decent work. Some believe the academic qualifications race is not beneficial, even detrimental.

Suppose there are two types of workers:

• High ability (H-types): marginal revenue product of $4000$ a month.

• Low ability (L-types): marginal revenue product of $3000$ a month.

50% are H-types and 50% are L-types.

The labour market is competitive, so workers are paid their (expected) marginal revenue product.

Education as a Signal: Asymmetric Information

If employers knew a worker's type, H-types would earn $w<em>H = 4000$ and L-types would earn $w</em>L = 3000$. However, employers cannot easily identify ability and pay all workers their expected marginal revenue product of $w<em>H = w</em>L = 3500$.

Low-ability workers benefit, but high-ability workers are hurt by the inability to distinguish between the two types. High ability workers have an incentive to credibly identify themselves, meaning that low-ability workers cannot or would not want to do the same thing.

University Education as a Signal

Suppose ability is pre-determined and university teaches nothing useful. The main reason people go to university is to earn more after graduating, and university requires costly effort. However, effort is less costly for high-ability workers.

A Signalling Equilibrium

Employers can observe who has a degree and who doesn't. If employers believe graduates have high ability and pay them $4000$, and non-graduates have low ability and pay them $3000$, these beliefs are correct if only high-ability workers choose to go to university.

It is observed that low-ability people have steeper indifference curves because effort at university is more costly to them, so they require greater compensation.

If the disutility of effort from university is low enough for high-ability individuals and high enough for low-ability individuals, university education is worthwhile for the former but not the latter.

In any signalling equilibrium, agents maximize their utility, and their actions fulfill their beliefs. When different types choose different actions, we have a 'separating' equilibrium.

Welfare Implications of Signalling

Firms make the same profits with or without signalling (zero). Workers earn an average of $3500$ with signalling: $$\frac{1}{2} "

The lecture covers analysis of hidden characteristics and screening in labor markets, with a specific focus on the following main topics:

1. Asymmetric Information

   • Definition of asymmetric information in transactions

   • Implications for informed and uninformed parties

2. Screening

   • Role of wages and their correlation with seniority

   • Differences in information regarding worker characteristics between applicants and employers

3. Screening: An Example

   • Description of a firm's hiring process

   • Analysis of worker types: L-type and S-type

   • Contract frameworks (short-term vs long-term) and their effects on attracting different worker types

4. Signalling

   • Concept of signalling and its relevance between informed and uninformed parties

   • Role of education in signaling ability to employers

5. Education as a Signal

   • The impact of education on job opportunities and employer perceptions

   • Analysis of high ability (H-types) versus low ability (L-types) workers

6. A Signalling Equilibrium

   • Mechanism of degree acquisition as a signal for employers

   • Conditions for establishing correct beliefs about worker abilities

7. Welfare Implications of Signalling

   • Effects of signalling on firm profits and worker earnings

   • Average earnings analysis with and without signalling