Like a market for "lemons," the labor market can also be affected by asymmetric information.Suppose a firm wants to hire more workers.The workers (or sellers of labor)know much more about their true productivity than the firm (or buyer of labor).The firm would like to hire workers and pay them according to their productivity but it is costly for them to hire workers,observe their behavior and productivity (do they work hard? are they on time?),and then fire those that do not perform well.Therefore,the firm would like to know how productive a worker will be before it hires that person.Can the firm acquire information (called a signal)about a worker's future productivity before hiring them? Can workers somehow signal their future productivity to firms?
This example is based on Michael Spence,"Job Market Signaling," Quarterly Journal of Economics,87 (August 1973),pp.205 - 221 and adapted from Ehrenberg and Smith,Modern Labor Economics,7^th edition,Addison-Wesley.
Assume there are only 2 types of workers,low productivity or high productivity.Workers with 16 years or more of education will be offered a wage leading to a present value of lifetime income of $2,000,000.Those completing less than 16 years of education are offered a wage leading to a present value of lifetime income equal to $1,000,000.
Suppose that the total cost of various levels of education is given by the equations C_A = 300,000(E-12)and C_B = 200,000(E-12)where type A workers are "low productivity" workers and type B workers are "high productivity" workers,and E represents years of education.
(a)What is the net benefit (difference between the present value of income and total cost)a type A person derives from attaining 16 years of education? What would be the net benefit for type A from 12 years of education? What is the optimal level of education for a type A person?
(b)Is 16 years of education an effective way to distinguish low-ability workers from high-ability workers? Why?
(c)Suppose firms raised the cutoff for the higher wage job to 18 years of education.Would this be an effective signal of worker productivity? Why or why not?
(d)To be an effective signal,what must be the relationship between the cost of acquiring the signal and a worker's productivity?
(e)How might grade inflation affect the effectiveness of the signal?

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