Efficiency Wage - Adverse Selection

Adverse Selection

The adverse selection model adds yet another flavour to our broad set of efficiency wage models. These use the framework that performance on the job depends on “ability”, that workers are heterogeneous with respect to ability, and that workers’ ability and reservation wages are positively correlated (workers know their own worth). In addition there are two crucial assumptions, that firms cannot screen applicants either before or after applying, and that there is costless self-employment available which realises a worker’s marginal product. If there are two kinds of firm (low and high wage), then we effectively have two sets of lotteries (since firms cannot screen), the difference being that high-ability workers do not enter the low-wage lotteries as their reservation wage is too high. Thus low-wage firms attract only low-ability lottery entrants, while high-wage firms attract workers of all abilities (i.e. on average they will select average workers). Thus high-wage firms are paying an efficiency wage – they pay more, and, on average, get more (see e.g. Malcolmson 1981; Stiglitz 1976; Weiss 1980). However, the assumption that firms are unable to measure effort and pay piece rates after workers are hired or to fire workers whose output is too low is quite strong. Firms may also be able to design self-selection or screening devices that induce workers to reveal their true characteristics.