Question

Illustrate a simple NUMERICAL model of job applicant signaling in the labor market.

Answer 1

The situation considered by Spence, typified by the job market, is one where some relevant information is available to only one side of the market (the potential employees), while the other side of the market (the employer) has to try to infer this information from some observable characteristics. Spence assumes that the population is divided in two groups: those with low productivity and those with high productivity. The employer does not know in advance whether a given applicant belongs to one group or the other and it will take some time before the true productive ability of the employee is revealed. It is therefore in the employer’s interest to try to guess the applicant’s productive ability on the basis of some characteristics that the employer himself can observe. Those observable characteristics which are under the control of the applicant (like education, the way he dresses, etc.) are called signals, whereas those characteristics which cannot be modified by the applicant (e.g. sex, race, etc.) are called indexes. It is clear that not every observable characteristic will be considered relevant by the employer. For example, the color of the applicant’s eyes (an index) or the color of his socks (a signal) are unlikely to be considered important by the employer, while the level of education is likely to be considered relevant. Therefore, within the set of potential signals the employer will select those that - in the light of her previous experience - seem to be correlated with productive capabilities.

This selection represents the beliefs of the employer. Suppose the employer believes that education is positively correlated with productivity. Then she will offer a higher salary to those applicants who have acquired more education. We therefore have a first flow of information, from the employer to the prospective employees: by differentiating salaries on the basis of some characteristics the employer reveals her beliefs. Employer’s initial beliefs Selection of signals within the set of all potential signals Employees “read” the employer’s beliefs in the wage schedule she offers Let us now turn to the other side of the market: potential employees. A potential employee will face the problem of communicating his unobservable qualities to the employer. The only way he can do this is by using some observable characteristic that can be modified by him, that is, by using a signal. In choosing a signal the potential employee must take into account two factors:

1) signaling costs, that is, the cost of acquiring that particular signal;

2) the employer’s beliefs, revealed by the wage schedule (it would be a waste of money and/or effort to acquire a signal which is known to be considered irrelevant by the employer, i.e. a characteristic to which the employer does not pay attention).