Adverse Selection in the Labor Market and Slow Recoveries

Abstract

In this paper I propose an equilibrium search and matching model with worker heterogeneity, asymmetric information, and endogenous separations, and argue that it can help our understanding of the U.S. labor market experience following the Great Recession of 2007–2009. Workers are heterogeneous in their ability, but a worker's ability becomes observable to a firm only after it hires the worker. This asymmetric information between former employers of a worker and his prospective employers has important implications for the response of the macroeconomy to shocks. I show that a deterioration in the distribution of ability in the pool of the unemployed leads firms to post fewer vacancies and to raise their hiring standards, thus lowering the job finding rates of all unemployed workers. The result is a slow recovery of employment and a shifting out of the Beveridge curve. I also theoretically characterize the impulse response of the economy to exogenous shocks to labor productivity and show that under plausible specifications of the general model the pool of the unemployed becomes more adversely selected in downturns. The model also provides an explanation for unemployment scarring: firms rationally discriminate against the long-term unemployed by demanding more unequivocally positive signals of their ability before hiring them. I further show that scarring is more severe for lower-ability workers and after deeper recessions. Finally, I discuss the relevant empirical literature and show that the evidence supports the predictions of the model.