Unraveling in Assignment Markets

Hao Li and Sherwin Rosen

No 5729, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We present a two-period model of the assignment market with uncertainty in the first period regarding productive characteristics of participants. This model is used to understand incentives toward early contracts or unraveling in labor markets for entry-level professionals. We study two contractual situations, one where firms are bound by ex post unsuccessful early contracts, and the other where they can buy out of unsuccessful early contracts. The economic benefit of unraveling is to provide insurance in the absence of complete markets, but it can come at the cost of inefficient assignments. Without reentry, unraveling need not occur. It is more likely, the smaller the applicant pool or the proportion of more promising applicants in the pool, and the greater the degree of heterogeneity in the pool. A ban on early contracts always hurts firms and benefits less promising applicants, but the welfare effects on more promising applicants depends on how the gains from early contracts are shared. With buyouts, inefficiencies in assignments are eliminated, and unraveling always occurs between firms and the more promising applicants. The efficiency gains of buyouts can be distributed unevenly and sometimes firms benefit from a ban on buyouts.

Date: 1996-08
Note: LS
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Published as American Economic Review, Vol. 88 (June 1998): 371-387.

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