Adverse Selection in the Labor Market

Abstract

This paper argues that adverse selection in the labour market, when viewed as part of a three-way interaction among workers, their current employers and a universe of alternative employers, may seriously impair a worker's freedom to change jobs. When current employers are better informed about the abilities of their workers than potential alternative employers, they will presumably concentrate their efforts to prevent turnover on their better workers. If these efforts lead to fewer quits among better workers, the stream of job changers should be composed disproportionately of less able ones. This will inhibit turnover in two ways. First, firms should be unwilling to hire from the job-changing pool except at low wages. Second, workers who change jobs are marked by being part of an inferior group, which lowers their future bargaining power and wages. Models of these phenomena can be made to account for many aspects of observed labour market behaviour. This paper argues that adverse selection in the labour market may seriously impair a worker's freedom to change jobs. Wage offers received by workers should be based on information available to the market at large. Yet, within any group of workers receiving comparable wage offers (presumably a group for whom the publicly available information is equivalent), current employers should be able to distinguish more from less capable workers. Firms should then concentrate on keeping their better workers, and, if these efforts are even partially successful, the stream of job-changers should be composed disproportionately of less able ones. Thus, whenever a worker leaves his present firm and enters a labour market, he may well be identified as someone whose ability is, in some expected sense, below average. This tendency has several important consequences. First, employers may be inhibited from entering the market whenever they seek to fill jobs that require especially good workers. They may rely instead on internal labour pools which, by itself, might seriously limit the extent of inter-firm mobility. Second, the marking process which accompanies any job change may impose a substantial turnover cost on workers who seek new jobs. As a job change becomes a publicly available part of a worker's employment history, it identifies him with the inferior group of workers in the job changing pool. This reduces future market wage offers and, in turn, what the worker's new employer must pay to prevent his departure. The consequent loss of future income might represent a major barrier to mobility. Third, wages in the secondhand market will be reduced, since employers must base their offers on the expected quality of workers who actually change jobs. Then, since alternative wages have declined, firms may reduce the wages that they pay to their current work force. The surplus return to firms implicit in these reductions will be bid away in entry-level markets. However, the net effect is to generate patterns of wages over the course of a worker's career (e.g. entry-level premiums, in the form either of implicit promises of lifetime incomes or the assumption by firms of general training costs, which are recovered through lower future wages) which may place an additional emphasis on reducing mobility.