Adverse Selection and Employment Cycles

James D Montgomery

Journal of Labor Economics, 1999, vol. 17, issue 2, 281-97

Abstract: This article examines a dynamic adverse-selection model that generates equilibrium employment cycles. In the model, firms hire workers from unemployment, observe workers' productivity through time, and (following the profit-maximizing rule) eventually fire unproductive workers. If hiring costs are low, the dynamical system converges to a steady state in which the unemployment pool contains mostly low-ability workers. However, if hiring costs are sufficiently large, this 'lemons effect' would make firms unwilling to hire workers. In this case, the system converges to a cyclical equilibrium in which firms alternate between hiring and not hiring. Copyright 1999 by University of Chicago Press.

Date: 1999
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