Question

1. Consider the following market in which workers can either be of high (H) or low (L) productivity. The outside option for both workers is 2. The productivity of L workers in the market is 2 and the productivity of H workers is 6. There are many firms in this market and they behave competitively.

Potential employers cannot observe the productivity of a worker ex ante, but they can verify the level of education a worker has received. The L workers have a utility function of UL = wL – eL, where wL is the wage their receive and eL is their level of education. The H workers have a utility function of UH = wH – eH, where wH is the wage they receive and eH is the education attainment.

Outline a separating equilibrium in which employers can distinguish between low- and high-type workers. Use a diagram to help in your explanation as to how this equilibrium works. What if the H-type workers have an outside option of 5.5 – what would happen in that case?

Answer 1

Workers with low productivity costs (C(l)) for minimum level of education which gives them less profit.

Workers with high productivity costs (C(h)) for minimum level of education and further education which gives them high profit.

If the firm offers average wages that is (2+6/2= 4), then low productive workers gets the benefits where are high productive workers losses as they gets much lower wages.

If the outside wages for high productive workers are 5.5, then they have incentive to move outside.