Adverse selection in wages

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Adverse selection in wages is the phenomenon of adverse selection maifesting itself in the labor market, where the seller of labor is the worker, the buyer of labor is the employer.

Typically, the seller (i.e., the worker) has more information about the quality of the labor being provided than the employer, and thus, the best workers tend to leave because their productivity is much higher than the average productivity according to which wages are determined.

It could also occur the other way: the employer has a much better idea of the effectiveness of the worker, and the worker overestimates his/her productivity. Thus, workers leave a well-paying job in search of elusive ones.


Suppose an employer has a large number of employees involved in producing boxes, but the employer has no way of monitoring how many boxes each worker is producing. Suppose there are 100 boxes produced per hour and a total of 10 employees. The employer will thus agree to pay each worker the wage equivalent for 10 boxes per hour.

However, each worker has a better idea of how many boxes she is producing. A worker producing 19 boxes per hour may find the wage too low for her skill level, and may therefore seek other employment. Thus, the employer loses his most productive worker. Now, an average of 81 boxes is produced per hour. The employer now agrees to pay each worker at a rate equivalent to 9 boxes per hour. An employee producing 12 boxes per hour now finds the wage too low and chooses to leave. This pushes the average production down further.

Since adverse selection is self-perpetuating, the employer is likely to lose several of the best workers because of an inability to determine which workers are most productive. The problem here is not just that employers have a poor idea of the individual productivity of workers, but also that workers are likely to have a better idea because they know how many boxes they are producing.


Efficiency wage

Further information: Efficiency wage combats adverse selection in wages

An efficiency wage is a wage that is higher than the wage that may be determined by demand and supply forces, negotiations with labor unions, and government regulations. In other words, employers are paying employees more than they need to considering the supply in the labor market. One reason for the efficiency wage is that it provides a slight cushion that may be enough to keep the most productive workers. (There are other reasons for the efficiency wage, including healthier, happier and more productive employees).

Better methods for estimating employee productivity

Employers may use a range of techniques, including computerized/camera methods for tracking and recording worker output in factories, and review of worker performance by peers, seniors, juniors, customers, and other people dealing with the worker.


Expository references

  • Naked Economics: Undressing the Dismal Science by Charles Wheelan, 10-digit ISBN 0393324869, 13-digit ISBN 978-0393324860More info, Page 81-90 (The Economics of Information: McDonalds didn't create a better hamburger)