6-2 Asymmetric Information and Signalling
[6.3 Incentives and Compensation]
One of the assumptions that drove the operation and efficiency of competitive markets was that buyers and sellers had perfect information about the quality of goods and services that were being traded. In reality, there are many commodities for which this assumption is not satisfied. For example, buyers of used cars do not know whether or not the car is a "lemon" (ie, will operate poorly), buyers of real estate may not know whether a new industrial development might occur nearby and traders in stocks may not have important information about the profitability of the company in question.
When an employer does not know a
candidate's true skill set, the candidate has an incentive to exaggerate his or
her true qualifications in order to get the job. How can employers obtain
accurate information?
Candidates often possess private information. In other words, they know their true worth but the employer does not. Private information creates problems for other possible job candidates and employers. Good job candidates do not want to compete against impostors, and firms want to be able to identify the good from the bad. Fortunately, there are solutions.
Signalling
Qualified candidates might be able
to send a signal
to potential employers that indicates that they are good
potential hires. For example, the employee may have some difficult-to-obtain
credential or an advanced degree from a good institution. View the following
animations for an overview of the signalling theory.
You have seen the problems posed in the first animation above. Now, to see how signalling can be used to solve these problems, view the animation here.
As discussed in the animation,
signalling works only when two conditions are met. First, the seller (ie, the
potential employee) must know his or her true quality. Second, a credible signal
must exist. If not, then the employee cannot signal. This means that an
employer must find a different way of determining the true skills of a
potential employee.
There are two basic methods used to
determine an employee's skill when he or she cannot signal it directly,
self-selection and screening.
Self-selection
The first requires that the employee
know his or her true skills (as in the signalling method). The company can set
up a job offer (pay structure, bonuses, benefits, etc.) such that only people
who truly possess the skills they claim to possess would accept the job. For
example, a firm might use a probationary period during which an employee would
be monitored closely. The firm would promote or retain only those who turn out
to be good performers or have the requisite ability. What is important here, is
that there is a reward – the promotion or high-paying job – associated with
proving one's skill. This generates an incentive, but the incentive is stronger
for the job applicant with greater skill. This concept is called self-selection.
Self-selection is not covered in detail in this subject. However for further information, click on the link here for a discussion of how to structure job offers to achieve self-selection.
A. Michael Spence of
Screening
Signalling and self-selection allows a firm to determine a worker's skills only when the
worker accurately understands his or her own skills. The second method, screening, is used when neither the employee nor the firm knows the
true skills of the employee. It is done either before hiring (through some test
or other certification process) or after hiring, by closely observing the
employee. It is used with the express purpose of determining the skills of a
potential employee and is often done well into an employee's tenure with the
firm to determine the appropriate job into which to place an employee. It is
similar to the self-selection method, but no incentive is used because job
applicants do not know whether they have high enough skills when they apply. This
concept will be explored next.
View the following animation to learn about the costs and benefits of screening.
Screening can be profitable for a
firm and it can also benefit the employees. If the employees are able to demand
a higher salary after being screened, they should be happy to be screened. Even
if the company will not pay for the screening, the employees will, because the
employees will receive the benefit.
The employee can pay for screening
in one of two ways. One way is for the firm to require that employees possess
some form of certification. As long as the cost to employees of taking and
passing that examination is less than the expected value of future wages, they
should be willing to do it. The other way is when the firm screens candidates
during a probationary period. Any employee who passes the screening will be
retained. Employees pay for this screening in the form of reduced salary during
the probationary period.
Click the link here for a mathematical explanation of the calculations a firm might use to decide whether or not to screen candidates.
To illustrate, think about a firm about to hire new employees. Assuming any given candidate will be either a good or a bad employee, the firm wants to hire good employees and reject bad ones.
The graphic below represents the desired outcomes of hiring decisions.
Each screening approach has costs
and benefits. Prehire screening generally results in the rejection of more good
candidates but, for the most part, will successfully screen out bad employees
as well. Screening after employees are hired will generally result in less of that
type of error, but it will result in more bad employees being hired. If it is
more costly to the firm to reject a good employee than to hire a bad one, then
on-the-job screening is preferable. On the other hand, if the employee can do a
great deal of damage to the firm's reputation during the probationary period,
the cost of on-the-job screening may be high, and prehire screening would be
better.
Click on the link here to see how screening and signalling is used in higher education.
Click here for details on your discussion activity.
In conclusion, firms can determine the productivity of potential new hires in a number of ways. One way is by signalling, where the applicant can send some credible information about his or her skills to the employer. Another way is by self-selection, whereby a firm structures an offer such that only the type of employee the firm wants to attract will accept. A further method is by screening, whereby some formal mechanism is used to determine an applicant's value to the firm, in cases where an applicant does not know his or her relative skill initially.
Topic Summary
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Asymmetric information can create difficulties in market transactions.
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Employees can send credible signals to reveal their productivity to potential employers.
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Employers can use screening to determine the productivity and other relevant characteristics of potential hires.
You may now proceed to topic 6.3, “Incentives and Compensation”.