Employment Dynamics in a Signaling Model with Workers' Incentives

Abstract

Many firms adjust employment in a "lumpy" manner -- infrequently and in large bursts. In this paper, I show that lumpy adjustments can arise from concerns about the incentives of remaining workers. Specifically, I develop a model in which a firm's productivity depends on its workers' effort and workers' income prospects depend on the firm's profitability. I use this model to analyze the consequences of demand shocks that are observed by the firm but not by its workers, who can only try to infer the firm's profitability from its employment decisions. I show that the resulting signaling model has pooling equilibria in which, for small negative shocks, the firm bears the costs of some labor hoarding in order to conceal negative information from workers and thus maintain their incentives for effort. However, if negative shocks accumulate then labor hoarding becomes too costly; at that point the firm drastically reduces employment.

Keywords: Asymmetric information, Displacement, Downsizing, Labor demand, Layoffs, Moral hazard, Signaling

JEL Classification: D82, J21, J63, M51