Learning About Match Quality and the Use of Referrals

Abstract

A theoretical model of the labor market is developed to study the firm's decision to use referrals as a hiring method. The labor market is characterized by search frictions and uncertain quality of the match between a worker and a job. Using referrals increases the arrival rate of applicants and provides more accurate signals regarding a worker's suitability for the job. The latter informational advantage leads to predictions regarding the correlation of a referral with wages, productivity and separation rates that are consistent with the data. The model is extended by introducing heterogeneity in firm productivity and allowing the endogenous determination of signal accuracy. In equilibrium, high productivity firms choose greater accuracy of signals which diminishes the informational advantage of referrals. This generates the predictions that high productivity firms use referrals to a lesser extent which biases wage regressions that ignore firm fixed effects.