A Theory of Dynamic Selection in the Labor Market
48 Pages Posted: 25 Jun 2016 Last revised: 28 Dec 2018
Date Written: December 27, 2018
I propose an equilibrium search and matching model with permanent worker heterogeneity, asymmetric information, and endogenous separations and study the dynamics of adverse selection in the labor market. The interaction between asymmetric information and endogenous separations leads to a cyclical adverse selection problem that has testable predictions both for the aggregate variables and for individual workers’ outcomes. First, a deterioration in the distribution of ability in the pool of the unemployed leads firms to raise their hiring standards, thus resulting in shifting out of the Beveridge curve. Second, if the separation rate is log-supermodular (log-submodular) in productivity and ability, the pool of the unemployed becomes more (less) adversely selected in downturns. Third, firms rationally discriminate against the long-term unemployed by demanding more unequivocally positive signals of their ability before hiring them. Fourth, this scarring effect is more (less) severe for lower-ability workers and after deeper recessions if the separation rate is log-supermodular (log-submodular). I conclude by providing conditions on the fundamentals of the economy that lead to log-supermodular and log-submodular separation rates.
Keywords: unemployment, slow recovery, unemployment scar, search, adverse selection
JEL Classification: E24, E32, J23, J63, J64
Suggested Citation: Suggested Citation