Specific Human Capital and Sorting Mechanisms in Labor Markets

Abstract

Three major avenues of research on employment contracts which incorporate asymmetric information have been pursued. First, researchers have considered contracts in which the supply of employee effort is costly to monitor [3; 8; 9; 12]. Second, the allocation of labor has been examined when innate person-specific characteristics are unobservable [4; 5; 14; 15]. Third, employment contracts have been designed when economic agents are uncertain about the state of nature concerning the worker's marginal product and the employee's reservation wage [6; 7]. This research agenda has provided an elaborate array of models which yield employment contracts that reduce the distortionary effects of asymmetric information. However, these models have two major short-comings. First, under uncertainty concerning personspecific information, employers have an incentive to screen employees. The existing literature has analyzed two distinct screening mechanisms. Guasch and Weiss [4; 5] consider screening through wages, while White [15] has considered screening through specific human capital. However, each mechanism has been analyzed in isolation. The present paper combines these screening mechanisms and examines the impact of each upon the optimal employment contract. Second, although the existing literature on employment contracts offers a general framework for analysis, it is not directly amenable to empirical verification. The present paper rectifies these short-comings by developing a model which incorporates both screening mechanisms under asymmetric information, and thereby provides a model conducive to empirical verification. In our analysis three major simplifying assumptions are made. First, because we assume employees have no choice regarding the effort they supply, we abstract from the agency problem discussed in the literature cited above. Second, we assume employees differ in their innate person-specific characteristics. The latter is assumed to be observed by