Question

. Suppose prospective clerical workers fall into one of two categories in equal numbers: high productivity (HP) and low productivity (LP). An HP worker's value to the firm is $30,000 per year; an LP worker's value is $20,000 per year. A firm hires workers who stay an average of five years.

A. At the time of hiring, the firm cannot distinguish HP and LP workers. In this case, what wage will it offer its new hires? What two word phrase describes the problem that you are facing?

B. One option is for workers to attend college before taking a job. Suppose college has no effect on clerical productivity (its other virtues notwithstanding). For an HP worker, the expected total cost of attending a four-year college (accounting for possible scholarships) is $40,000. The expected cost for an LP worker is $60,000. Can HP workers effectively signal their productivity by attending college? What if the average job stay is only three years?

Answer 1

At the time of hiring, if the firm is unable to distinguish HP and LP workers, the firm would pay the hired individual the expected worker's value amount as per the given information in the market.

Since we have HP and LP in equal numbers, the average amount would be 0.5X$30,000 + 0.5X$20,000, that is, $25,000.

This is the classical case of the principal agent problem, know as adverse selection. At the given salary of $25,000, the only individuals who would be willing to work for the firm would be the LP workers since the HP workers would not be willing to work for less than $30,000.

HP workers can effectively signal their productivity if the average job is only three years, since they'd earn $30,000 each years and they can easily recover the cost of college in less than 2 years.