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Baltic State Technical University

International Business & Communication Institute

Master of Business Administration & Engineering

Economics project work

Asymmetries of information in labor market

Executed by Vecherskiy G.S.

Scientific chief: Loukitchev P.M.

Saint-Petersburg 2019

Contents

• Introduction
• 1. Asymmetry of information and its place in the modern society
• 2. Asymmetries of information in the Russian labour market
• 3. Consequences of the asymmetrical information
• 4. Ways of coping with the asymmetries of information in labour market
• 4.1 Michael Spence's signaling, signaling equilibrium
• 4.2 Stiglitz's screening
• 5. Self-selection
• 5.1 Probationary Periods
• 5.2 Increasing Wage Profiles
• 5.3 Performance-Based Pay
• 5.4 Other Tools
• Conclusion
• References

Introduction

Our modern life is changing rapidly. Every day we make new decisions. And one of the major conditions of rational decision making is information. However, information, as all economic resources, is often limited. Decision made under uncertainty or incomplete information involves risk, which has the consequences. Such decisions often turned out to be mistaken, less beneficial, and more expensive than we had expected. But, unfortunately, we always have to pay for our mistakes. Besides, we have to pay for insuring ourselves from mistakes as well. These problems concern all market subjects: both consumers, and manufacturers, both buyers, and sellers. Uncertainty becomes a serious barrier on a way to the effective market achievement. This leads to undesirable expenses of forces, funds, time and energy, nonoptimal distribution of the goods and resources. But, also, when we possess the accurate information that doesn't guarantee success, this only significantly facilitates its achievement, contributes to increase of the efficiency of coordination and optimal distribution of the resources.

In real life we face asymmetry of the information every day, when we see people gambling, when we go shopping, and also offering the services etc. Organizers of gaming business are better aware about its details, than ordinary participants; sellers of goods are informed about its quality much more, than buyers; the insurance company's consumers have more information about objects of insurance, than the company itself. Market prices, as it turned out, enclose not only the reflection of the fact of supply and demand curves crossing.

Potential sellers (as well as potential buyers) hide veritable goals of their behavior, use different ways of achieving personal benefits. Market mechanism turns out to be unsound in view of information incompleteness (asymmetry).

The purpose of this project work is to give a good overview of the asymmetric information theory with reference to the labour market. I'm considering the theoretical aspects, applications and methods of avoiding the asymmetries based on economic literature.

1. Asymmetry of information and its place in the modern society

Why are brand goods popular? Why does a McDonald's make more sales than a local competitor next door? Why do some people prefer to buy used cars from a used car salesman rather than from an individual? Of two job applicants with similar skills, why does the one with higher qualification get the job? All of the above, brands, used car salesmen, degrees and qualifications are examples of market institutions set in place to level information asymmetries.

It is empirically clear that people possess different information. The information they possess affects their behavior in many situations. Consider buying goods, for example, the seller adjusts the price of an item based on his knowledge of the prices of similar items on the market and the condition of the item among other factors. The buyer similarly can have information about the prices of similar items in the market. But what he probably does not have is the same depth of information about the quality of the item as its seller. There is clearly an information asymmetry between the two parties at issue.

The concept of information asymmetry was able to explain many common phenomena that could not be otherwise explained when it was first introduced in the early 1970s. Since then it has become a valuable tool in the field of economics and it is used to explain a diverse set of phenomena. Its significance was established well before the year 2001 when the original authors of the theory, George Akerlof, Michael Spence and Joseph Stiglitz received the Nobel Prize in Economic Sciences for their analyses of markets with asymmetric information.

In economics and contract theory, an information asymmetry (or state of asymmetric information) is present when one party to a transaction has more or better information than the other party. Most commonly, information asymmetries are studied in the context of principal-agent problems. Information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry. Examples of this problem are adverse selection and moral hazard.

Information asymmetry models assume that at least one party to a transaction has relevant information whereas the other(s) do not. Some asymmetric information models can also be used in situations where at least one party can enforce, or effectively retaliate for breaches of, certain parts of an agreement whereas the other(s) cannot. In adverse selection models, the ignorant party lacks information while negotiating an agreed understanding of or contract to the transaction, whereas in moral hazard the ignorant party lacks information about performance of the agreed-upon transaction or lacks the ability to retaliate for a breach of the agreement. An example of adverse selection is when people who are high risk are more likely to buy insurance, because the insurance company cannot effectively discriminate against them, usually due to lack of information about the particular individual's risk but also sometimes by force of law or other constraints. An example of moral hazard is when people are more likely to behave recklessly after insured, either because the insurer cannot observe this behavior or cannot effectively retaliate against it, for example by failing to renew the insurance.

As I have already mentioned, the concept of asymmetric information was first introduced in George A. Akerlof's 1970 paper The Market for "Lemons": Quality Uncertainty and the Market Mechanism. In the paper, Akerlof develops asymmetric information with the example case of automobile market. His basic argument is that in many markets the buyer uses some market statistic to measure the value of a class of goods. Thus the buyer sees the average of the whole market while the seller has more intimate knowledge of a specific item. Akerlof argues that this information asymmetry gives the seller an incentive to sell goods of less than the average market quality. The average quality of goods in the market will then reduce as will the market size. Such differences in social and private returns can be mitigated by a number of different market institutions. For example, counteracting institutions can reduce the asymmetry of information between parties in a market. A good example of such an institution is guarantees for goods. A guarantee allows the buyer sufficient time to reach the same level of information about the good as the seller before the buyer assumes full risk of the good being a lemon. Brand-names, chains and franchising are other examples of such market mechanisms that guarantee the buyer at least some level of quality. They also allow the owners of better than average goods to get the full value of their product when sold. Consequently they keep the market from reducing to the size of zero.

Well, it's enough discussion for asymmetries of information in general. The next chapters are devoted to the labor market and asymmetrical information that takes place between employers and employees.

2. Asymmetries of information in the Russian labour market

Talking about information in labour market we're dealing with three flows of information. The first is information about conditions of job payment, substance and nature of a job, labour hours, vacations, privileges and compensations, social security and services and many other factors characterizing the quality of life of work in a prospective place of employment.

The second flow of information is data about prospects of the firm which is being chosen by employee, e.g. competitive abilities of the firm's production, its financial state, managers' and chiefs' qualification, social climate in collective etc.

The last body of information is data about labour market conditions in the place (region or country) where an employee is going to hire. This type of information includes: average wages rates according to different professions and qualifications on the whole and separately in each industry and even firm, level and structure of employment and unemployment.

It's obvious that information concerning levels of supply and demand in the labour market can't be exhaustive, but, however, every person, looking for a new job is trying to maximize the volume, completeness and authenticity of such information, because this increases chances to make an optimal decision.

Unfortunately, I have to admit, that informational infrastructure of the Russian labour market is unsatisfactory. Employers in labor markets often posses more information about the current and future status of their industry than trade unions and workers, and can use this as a basis of negotiation.

On the other hand the employer is not sure of the productive capabilities of an individual before hiring him. Here we have the bilateral asymmetry. Even after hiring the productive capabilities are not immediately clear as some job specific training and learning has to take place. In this case bad workers or employees with low production capability could be compared with “lemons” in the automotive market.

One of the weakest spots in a labour market supply with information is hidden data about workers' wages. The enterprises (especially small and average) suppose that such data is commercial classified information. It is almost impossible to find statistics about wages of different specialties and qualifications, which are necessary for making optimal economic decisions by labour market subjects.

In the western countries, in particular the USA, the publication of detailed statistics about the salary is usual practice. This data serves as a reference point in negotiations between workers and businessmen about payment conditions. Lately, many subjects of Russian Federation have provided information about a living wage. However, the majority of the population is not aware with a technique of its calculation. Data about the number, level and duration of unemployment began to appear in the early 90s, but frequently they were incomplete and inconsistent. The statistics, published today, based only on number of the unemployed people, who are officially registered in territorial bodies, this disfigures a real picture (by independent calculations, unemployment is several times bigger). As a result, trade-unions and ordinary workers aren't able correctly define the economic behavior.

Incompleteness, and, as a result, asymmetries of information in labour market makes lots of problems both to the employers and employees, which in one's turn have an impact on the society. The consequences of asymmetrical information are discussed in the next chapter.

3. Consequences of the asymmetrical information

In my opinion, the major economic and social consequences of information asymmetry and incompleteness in a labour market are: inadequacy economic behavior of subjects in a labour market, different types of discrimination (sex, age, nationality), and growth of frictional unemployment, which is, probably, the most serious problem that is partly caused by asymmetrical information.

Hired workers (trade-unions), lacked of sufficient information about labour market conditions (wages, employment, unemployment structure), sometimes make nonoptimal economic decisions. They turned out in an unfavorable situation while negotiating with employers and representatives of the government about payment conditions quite often make unwarrantable demands to the payment level (for example, St.-Petersburg independent trade union "Justice" without an accurate substantiation demanded immediate increase of wage's rates up to 50 % of cost of production). Employers, in their turn, commit errors in personnel selection and in establishing the rates of payment and other errors.

Serious miscalculations in substantiation of a policy of incomes, wages and employment are made by experts. The reasons for this are the information incompleteness and imperfection methods of its processing, analyzing and forecasting social and economic processes etc.

Let's consider on an example, what problems can age discrimination cause. Analyzing more than 2'000 bulletins experts came into conclusion that more than 30 % of publications contained restrictions on age. It's not a secret that the majority of employers strive for employing candidates at the age from 20-25 till 40-45 years.

The impossibility to find work as 50-year-old people negatively affects not only their psychological and physical condition, but also on their ability to invest assets in the education of their children, that repeatedly strengthens negative consequences of this kind of discrimination.

Information asymmetry leads to growth of frictional unemployment. Its reasons are different, but one of the most powerful - a dissatisfaction with level and the wages organization (according to the results of the sociological inspections spent in the Russian cities this is the main reason for leaving the entire job for about 70% of leaving). However in the absence of the information on working conditions in other firms the decision not always is optimal. Searching for a new job lasts for the about one month during which candidates remain unemployed. Fluctuations of a labour lead to frictional (fluid) unemployment, which reaches in the Russian labour market about 20 % of the average number in annual calculations.

Such labour force fluctuations causes certain damage both to workers, and a national economy, creates additional expenses connected with moving of workers, dismissal and employment, decline of productivity before leaving from an old place of work and in an initial stage on new (though under certain circumstances voluntary moving of a labour allows everyone to realize more full the personal potential and to raise efficiency of work).

If workers possessed an exhaustive market information of job market conditions such as rates of a payment many of them, most likely, would not accepted precipitate decisions on change of a place of work. The economic and social losses connected with labour moving would be minimized, and level of frictional unemployment would not become more than natural (2-3 % of economically active population).

Economic and social losses of a society from unemployment growth are rather essential: first, the volume of gross national product and efficiency of use of production assets decreases; secondly, labour market tension increases, that reduces the labour price; thirdly, welfare standards are getting worse in families where there are unemployed; fourthly, qualification and professional skills of the workers who have remained without work is losing; fifthly, unemployment, especially among youth, is the reason for poor behavior and increase of the marginalia level of its parts. Certainly, we are far from that all these consequences of unemployment growth to write off on information asymmetry.

However, as has been shown above, it has certain influence on scales of the basic form of unemployment - frictional unemployment. And, in the very end we're faced economical and social loss, because of the increase of unemployment.

4. Ways of coping with the asymmetries of information in labour market

4.1 Michael Spence's signaling, signaling equilibrium

Michael Spence continues the ideas of George A. Akerlof in his 1973 paper Job Market Signaling. He divides markets into two classes: those where there are few players in the market and they can establish a reputation as signalers and those where the players in the market are numerous and change frequently. Spence concentrates on the latter market where signals need to be interpreted without prior knowledge of the individual signaler. He uses job market as an example in the paper.

Spence models hiring employees as investment decisions made under uncertainty. The employer is not sure of the productive capabilities of an individual before hiring her. Even after hiring the productive capabilities are not immediately clear as some job specific training and learning has to take place. Spence reasons that because the capabilities of an individual take time to learn, hiring is an investment decision, and because the capabilities are not known beforehand with certainty, it is an investment decision under uncertainty. Spence parallels such an investment decision with a lottery.

The employer perceives a certain chance of winning in the lottery and a certain chance of losing. This chance of winning is determined by his prior experience in the job market and the signals a job applicant transmits and the indices she has. In Spence's terminology indices are immutable characteristics of an individual, like race or sex, whereas signals are the characteristics of an individual that the individual can manipulate. Spence uses education as the example manipulable signal in his model of the job market.

Using previous experience from the job market the employer can assign conditional probabilities to levels of productivity given a set of signals and indices. After hiring new employees and observing their behavior the employer adjusts his view of the probabilities.

Potential employees in this model, on the other hand, confront offered wage schedules based on their signals and indices. As they cannot change their indices, the model becomes from their viewpoint one of optimizing their wages reduced by their signaling costs. Signaling costs are the total costs of changing a signal, including money, time and psychic costs. Spence sets a critical assumption for the validity of the model that costs of signaling should be negatively correlated with productive capability. In the job market example this means that getting a qualification or a degree should be easier for more productive people.

We now arrive at Spence's model of information feedback in the job market (figure 1). In this model the job market works in iterations. First the applicants decide on their signaling based on maximization of the offered wages net of signaling costs, then the employer hires the applicants, observes their productive capabilities and adjusts his conditional probabilistic beliefs. Lastly the employer presents a new set of offered wages as a function of signals and indices and then the iteration starts again.

A signaling equilibrium is generated when the employers' beliefs are confirmed by the signaling they generate through the offered wage schedule. Signaling equilibrium is a stable state where the sellers (potential employees) in the market differentiate themselves from each other by signaling and thus reduce the information asymmetry between themselves and the buyer (employer). So, where in the asymmetric model without signaling the market size reduced to zero, signaling enable equilibrium to be generated with a market size of greater than zero.

Figure 1: Informational Feedback in the Job Market

Spence goes on to study the use of indices in place of signals. He studies sex as the differentiating index. The conclusion is that two groups with the same distributions of productivity, men and women, may after some time end up in different equilibrium. Based on the employees hired and their capabilities the model develops into one of the equilibria. This equilibrium may be different for the initially equals groups and can encourage different approach to acquiring education or to other signals. This leads to what Spence refers to as a lower level equilibrium trap. This equilibrium, once acquired persists due to endogenous factors of the model and the equilibrium state. For example, the level of compensation for the lowest level jobs may be sufficiently high compared to education costs that most of individuals in a group prefer the lower level jobs.

By simple and sometimes more rigorous mathematical modeling and proof, Spence could examine different situations and general properties of the signaling theory. Here are the most obvious findings that Spence made.

Finding 1: No signaling. If signaling is not possible, the expected marginal product is same for both low-productivity individuals and high-productivity individuals. The former ones are better of and the latter ones are hurt, because the wages or returns are determined by the average productivity of the people. This is the problem of adverse selection identified by Akerlof (1970).

Finding 2: Signaling equilibria. Given that signaling is possible, equilibriums will exist. The equilibria are not unique; there are multiple and often continuous spectra of equilibria, in terms of different employer belief set.

Finding 3: Effect of indices. Different groups of people distinguishable through an index (e.g. race) settle into signaling equilibrium configurations independently of each other, and independent of the fact that the index may be uncorrelated with productivity. Thus the interaction of indices and signals creates the possibility of arbitrary differences between the equilibrium signaling configurations of two or more distinct groups.

Finding 4: Differential signaling costs. If signaling costs are different between two groups of a population, distinguished by an index, “the unprejudiced employer will tend … to compensate for the group facing higher signaling costs”. This will happen automatically based on past market data.

Finding 5: Suppressing indices. A signaling mechanism can allow different groups, as defined by an index, to settle in different signaling equilibria. This may lead to a natural need for the seller (job applicant) to suppress the index, i.e. somehow try to prevent the buyer (employer) from observing the index. If the source of the unequal treatment of the groups is an arbitrary difference in the equilibrium situation, and the groups otherwise have similar productive capabilities and signaling costs, then suppressing the index will remove the unequal treatment.

If the source of the difference in equilibrium results from differences in signaling costs, then suppressing the index will lead to wage discrimination and hurt the high-signaling-cost group. labour market russian

The idea of signaling was also presented by George A. Akerlof, but he dubbed the signals indicators. As Spence's paper was published first, the term signaling is prevalently used in the literature.

All in all, qualified candidates might be able to send a signal to potential employer 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.

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, which will are discussed below.

4.2 Stiglitz's screening

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, which will be discussed next, but no incentive is used because job applicants do not know whether they have high enough skills when they apply.

So, screening can be identified as the process by which a firm can assess the skills of a candidate or an employee in order to make employment decisions about that person.

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.

In Spence's paper the employees in the market select the signals they want to transmit in order to choose a suitable wage schedule. Joseph Stiglitz in his 1975 paper The Theory of 'Screening,' Education, and the Distribution of Income explore whether this could be used by the seller (employer) to screen the applicants (potential employees) into categories that reflect their productivity or some other capability.

Stiglitz states that there are many important differences in the qualities of goods, individuals, brands and other items. He defines screening as identifying these qualities. Further, devices that perform screening activities are called screening devices.

Stiglitz develops the theory of screening using a simple model. Each individual has one characteristic, , which directly tells his productivity. In a non-screening situation each worker will receive a wage proportional to the mean productivity of workers. If those workers with higher can be identified, they will receive higher wages. The high- individuals thus have an economic incentive to be identified. For simplicity, the model further assumes that there are only two kinds of individuals, with productivities of (high) and (low).

Stiglitz then introduces a screening process, which costs c per individual to perform, and is able to perfectly tell the two kinds of individuals apart. It is assumed that the cost c is more than the difference of wages justified by productivity of and the mean wages, and that the cost c is also less than the difference of wages justified by productivity of and that of productivity of . Stiglitz argues that there are two possible equilibria for this model (i) non-screening equilibrium and (ii) full-screening equilibrium. In the non-screening equilibrium all workers receive the mean productivity wages and as the cost of screening is more than the gain available, workers do not have an incentive for screening. In the full-screening equilibrium all workers receive wages of the lower productivity group if not screened into category. workers now clearly have an incentive for screening and will pay the cost c of the screening process. individuals do not benefit from the screening and thus will not pay for it.

From this model Stiglitz makes some important observations. For example, the presence of the lower productivity individuals lowers the income of the higher productivity individuals, and on the other hand, the presence of the higher productivity individuals may increase the income of the lower productivity individuals. Furthermore, the social and private returns of screening- by education, for example-differ. Screening involves costs, but only serves to redistribute the income in the population, so the social return is negative. The individual, on the other hand, may increase her own income, so the private return is positive to the high productivity individual screened.

Stiglitz continues to argue why having screening processes may still be better for the whole population than having no screening processes even though the social return of such an institution is negative. For example, he proposes that matching individuals to suitable groups and jobs happens only under a screening process and results in social returns. In the rest of the paper Stiglitz discusses the education system as a screening device in more detail.

Spence's concept of signaling can, in Stiglitz's terminology, be seen as a screening device. Conversely, screening aims at leveling information asymmetries between parties in the market, so screening could also be labeled an instance of signaling.

Later, Michael Rothschild and Stiglitz in their 1976 paper Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information continues the work of Stiglitz. In this paper they study the effects of imperfect information using insurance market as an example.

Sanford Grossman and Oliver Hart provided another example of using asymmetric information theory in examining the job market in their 1983 work. They study the information difference between firms and their workers and the information that is revealed by the firm when it chooses a level of employment.

5. Self-selection

This method 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.

In other words self-selection is a process through which employees, based on their private information, choose an option that is most valuable to them, thus revealing certain information that only the employees know.

One difficulty in hiring is the potential for a candidate to be untruthful. A firm can almost never be certain that a candidate is telling the truth about previous experience or qualifications because candidates have an incentive to exaggerate in order to get the job.

A solution is to structure the offer of employment in such a way that candidates will accept job offers only if they are truly as good as they say they are. In other words, the offer must be attractive to the type of employee the firm desires but unattractive to the undesired.

5.1 Probationary Periods