CHAPTER 2 – RECRUITMENT

How firms bring employees into the organization and patterns of careers they have once they are there

After completing this chapter, you will be able to answer questions such as:

1. How can I reduce interviewing and hiring costs for my firm?

2. Should credentials be required when hiring?
3. How would I implement a probationary hiring system?

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 INTRODUCTION
CAREER PATTERNS IN ACME INC

 Management ranks have 8 hierarchical levels, from entry (Level

1) to CEO (Level 8)
 Most management employees in the first 4 levels
 At Levels 2-8, most employees were not hired from the outside
but promoted from within  managers in upper levels have
substantial experience in the firm on average
 Movement between levels (promotion) is more rapid at lower
levels

Two patterns:
1) Many leave Acme very quickly after being hired  evidence of sorting in the first few years on the job

2) If employees survive the sort, they often enjoy careers at the company that last for many years 
value to having employees remain with the firm

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 SCREENING JOB APPLICANTS

 Once your firm has decided which types of workers to hire, it must recruit for those types
 Two general issues:
 how weed out undesirable applicants
 how attract the right types of applicants

 The problem arises because of asymmetric information: One party knows what type they are (in this case, a
high or low quality job candidate), and the other does not
 If the firm offers a wage equal to the average productivity, only the wrong kinds of workers are attracted to the
firm  adverse selection

 A number of approaches can be used to mitigate the problem of adverse selection in recruiting

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 EFFICIENCY WAGES

 One strategy for attracting good quality job applicants: offer high level of pay or benefits:
 Assumption: reservation wage function of ability (better outside options) 
 Low wage: only low-productivity applicants
 High wage: larger pool of applicants and higher average quality

Example:
L (20%) M (40%) H (40%)
Reservation wage 16k 21k 24k
Productivity 32k 44k 56k

1) w=16+ε  only L profit per worker Π=32-16=16

2) w=21+ε  L and M profit per worker Π= (32-21)+ (44-21)=19

3) w=24+ε  all types profit per worker Π= (32-24)+ (44-24)+ (56-24)=22.4

 Higher wage related to higher profits (wage is not only a cost)

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 EFFICIENCY WAGES
 Generalizing with two types of workers:
High productivity: Low productivity:
 Productivity MPH  Productivity MPL < MPH
 Reservation wage wH  Reservation wage wL< wH
 Share qH  Share 1-qH

 Profits if w=wL  ΠL= MPL-wL

 Profits if w=wH  ΠH= qH(MPH-wH)+(1-qH)(MPL-wH)
 More profitable wH if
ΠH > ΠL
qH(MPH-wH)+(1-qH)(MPL-wH)>MPL-wL
qH(MPH-MPL)>wH-wL
 wH more profitable:
 the higher the share of highly productive workers
 the higher the productivity gap
 the lower the reservation wage gap

 Drawback: hired also low productivity workers (lower profits compared to no asymmetric information, see example)
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 CREDENTIALS
 An approach is to look for credentials (e.g. job and promotion history, type of training, quality of school
attended) that distinguish some applicants from others
 What makes a credential useful for hiring?
1. Informativeness of the Credential
 positive correlation between ability to obtain the credential and ability to perform well on the job

2. Cost of Obtaining the Credential

 it should be easier for well-qualified workers to obtain compared to poorly qualified workers
 on the other hand, a credential extremely expensive for all workers few applicants will have it (also
well-qualified)
 For a credential to be effective, it must be that most qualified applicants possess the credential
while most unqualified ones do not
3. Return on investment in the credential
 If the difference in wages between those who have credentials and those who do not is not very
great, small differences in credentials will signal large differences in ability

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 SCREENING

 Suppose that you selected a subset of candidates with appropriate credentials

 What should you do next? It make sense to expend some resources to screen them further

 There are a variety of methods that firms use to screen applicants: tests to see how they perform on
specific tasks, psychological profiling, personal interviews…

 All of these examples involve some costs

 To what extent your firm should invest resources in screening applicants carefully?

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EXAMPLE: Screening Bankers

TYPE
A B C D E
% of job applicants 10% 20% 40% 20% 10%
Investment bank -250 0 125 200 450
Productivity
Commercial bank 95 100 110 120 125

 Each bank expects to pay 100,000

 Investment bank would want to avoid A and B types
 Commercial bank would want to avoid A types

 No screening:
 Both banks have 110,000 average productivity from each new hire and average profit of 10,000

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EXAMPLE: Screening Bankers
 Applicants can be put through a series of tests that cost 2,000 per person and give definitive information
on which type the applicant is. How valuable is such information?

 Investment bank
 Would reject A and B, and accept 70% of all applicants
 Average productivity of C, D and E hired would be about 193,000
 Screening cost per worker actually hired would be 2,000 x 10/7 (2,857 per hire)
 Average profit from each new hire would rise to about 90,100  profit greatly from screening applicants

 Commercial bank
 Would reject A
 Average productivity would rise to about 112,000
 Screening cost of 2,000 x 10/9 (2,222 per hire)
 Profit per new hire would fall to about 9,800  not benefit from screening
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EXAMPLE: Screening Bankers

 Why the difference?

1. Investment bank screen out three times as many workers as the commercial bank. The point of
screening is to avoid hiring the applicants who would not be profitable
2. Downside from hiring poor candidates worse at the investment bank; more at risk from hiring the
wrong type of worker

 In general:
 Screening is more profitable when the test is more effective: cheaper to administer, more accurate
(correctly distinguish between desirable and undesirable job applicants), more discriminating (it weeds
out a higher fraction of candidates, recommending a smaller fraction for hiring)
 Screening is more profitable when the stakes are higher: the greater the downside risk from hiring the
wrong person, the more value there is to screening. Similarly, the longer that a new candidate can be
expected to stay with the employer, the more valuable will be the screen

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SCREENING JOB APPLICANTS (FORMAL ANALYSIS)

 Two types of job applicants:

 E (productivity QE, probability p)
 D (productivity QD, probability 1-p)
 QE > QD

 The firm pays wage W to those it hires such that QE > W > QD
 profit from E types, but loss from D types

 Expected profit from random new hire:

− + (1 − ) −

 The firm has a screen available that costs s, with accuracy q

 Expected profit with screening
− + 1− 1− − −

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SCREENING JOB APPLICANTS (FORMAL ANALYSIS)
 Change in profits from screening compared to not screening:

∆ =− 1− − − 1− − −

 First term negative (loss from mistakenly rejecting candidates of type E)

 Second term positive (gain from appropriately rejecting D types)
 Third term is also negative

∆
>0
∆
<0
∆
<0

 The test is more effective when it is

 More accurate
 Cheaper
 More discriminating

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SIGNALING

 Screening methods described above may be useful, but are imperfect: only proxies for how the person actually
performs the job

 In some cases, firms may use signaling in addition to screening

 Workers generally have a good idea about their skills (work ethic, ambition, …)

 If workers share this information honestly with employers, a firm could recruit employees of a certain type

 Not an effective approach…

 Suppose that through screening the bank to weed out Types A through C easily, but harder to distinguish between
Types D and E (the bank would like to hire E)
 Instead of screening, it can construct a job offer involving probation, up-or-out promotion, and a raise on
promotion that is attractive to the E types, but not to the D types
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SIGNALING (EXAMPLE)

 Two year contract, wage W1 and W2

 The bank can figure out what type an employee is after observing them on the job for one year

 The accuracy of this judgment is not perfect: 10% of the time, the wrong decision is made
 10% of D types are promoted when they should not be
 10% of E types are not promoted when they should

 In other jobs:
 D types can earn 175,000 (350,000 for two periods)
 E types can earn 200,000 (400,000 for two periods)

4. Selezione avversa e reclutamento 14

 Value of applying for D = + 0.9 175+0.1

Value of applying for E = + 0.1 200+0.9

 Probation can generate good self selection if the firm pay a sufficiently low amount during probation, and a
sufficiently high amount after probation
 The firm is demanding that each applicant post a bond (accepting less than they could earn elsewhere) during
probation and in return if they perform well and are promoted the firm will give them a reward (by paying them
more than they could earn elsewhere)

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 Type E receive a smaller reward on promotion, and pay a larger cost during probation, than do type D:
 Up-front bond (W – W1) larger for E, since their outside alternative is larger
 Deferred reward (W2 – W) smaller for E

 How can this type of job offer deter them from applying D, while motivating E types to apply?

 The evaluation must result in sufficiently high probability that E types will be promoted, and sufficiently low
probability that D types must be promoted: the low success rate for D types reduces the expected value of the
job for them compared to E types.

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 This discussion illustrates the general economic idea of signaling:
 High quality type signals his or her type to the market by incurring a cost
 If low quality types are not willing to incur this same cost, then the signaling is effective: the fact that
someone incurs the cost proves that they are the high quality type

 In our employment example, Type E’s can signal their type (and confidence in their ability to perform well
and earn promotion) by their willingness to accept low pay in the first period

 This only works if the D types are not also willing to accept the same contract

 Another application of signaling in the business world is when venture capitalists demand that entrepreneurs
invest all of their family’s personal funds in a new business venture

 This helps the venture capitalist separate out the most confident and serious candidates from the least

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SIGNALING AND PROBATION (FORMAL ANALYSIS)

 We now incorporate signaling into the probation model described above and show how the wage must be
structured each period to ensure signaling

Assumptions
 There are types E and D, as defined before
 The firm offers W1 and W2 in two periods
 In period one, workers are observed on the job
 those deemed to be good fits are promoted and paid W2
 the rest are fired and earn their outside pay
 q is the accuracy of the promotion decision

 Outside alternatives respectively WE and WD with WE > WD

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SIGNALING AND PROBATION (FORMAL ANALYSIS)

 In order to deter D types, but attract E types, we must meet both of these conditions

+ 1− + <2 (1)
+ + (1 − ) >2 (2)

.
 (1) says that D types expect to do worse at this firm
 (2) says that E types expect to do better

 This scheme can induce self selection if:

< + 1− − <
And
−
> + >

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SIGNALING AND PROBATION (FORMAL ANALYSIS)
 In fact, the optimal wages (that minimize compensation cost) are:
1−
= − ( − )
2 −1

2−
= + ( − )
2 −1

 These imply that W1 < WD < WE < W2 (deferred pay)

 It is easy to see that:
 The more accurate the test (larger q), the larger is W1, and thus the smaller is the bond posted by E types
 W2, and thus the reward on promotion, is smaller the more accurate is the test (E types more willing to accept since there
is less chance of a mistake)
 The smaller is WD, the smaller is W1
 The larger is WE, the larger is W2
 The larger the differences in productivity between the two (( − ), the larger the reward on promotion

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 PERFOMANCE-RELATED-PAY AS A SCREENING MECHANISM

 Performance-related-pay is an alternative approach that may induce candidates to self-select

 Intuition: high/low productivity candidates will/will not accept because they will be paid a high/low wage
 2 types:
High productivity: Low productivity:
 Productivity yH  Productivity yL < yH
 Reservation wage wH  Reservation wage wL< wH

 If production is measurable, the firm pays w=by

 Through the right choice of b the firm can attract/weed out the H/L types
 H applies if byH>wH --> b>wH/yH
 L does not apply if byL<wL --> b<wL/yL
 Necessary condition: wL/yL>wH/yH
Example

L (20%) H (40%)
b x 56 > 24  b>0.43
Reservation wage 16k 24k b x 32 < 16  b<0.5
Productivity 32k 56k 0.43<b<0.5

 Problem: measurability of production

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EDUCATION AS A SIGNAL

 Assume students learn nothing useful in school but more talented students find it easier to learn the
material quickly

 Then they might be able to signal their talents to the labor market by investing in more education than less
talented students

 The labor market recognizes this, paying more to those who have obtained more schooling (indeed those
with more schooling do earn more)

 There is evidence that education does have some role in screening workers, for example, those who almost
complete four years of college earn less than those who go a little bit further and complete their degree
(formal credential), hard to explain by training alone

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SIGNALING (FORMAL EXAMPLE)

 Junior accountants can invest in some education or on-the-job training

 If they complete the training, they become Certified Public Accountants (CPAs)

 There are two types of accountants:

 “quicks” (fraction α), more productive and find it easier (less cost) to become CPA
 “slows” (fraction 1–α)

# = employee′s productivity
3# = 4 5 6 7 78 ℎ: 3;< 4 :=:7 6>
= ,

 Labor market pays accountants their expected productivity  if cannot tell the two types of accountants apart
pay to all
@ = A B + (1 − A) C
NB:
@< B
D
@> C

 Adverse selection
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 If the quicks do succeed in distinguishing themselves, they will be paid their productivity

 Those who do not signal will then be assumed to be slows, and paid Qs

 In order for signaling to work it is necessary that:

B − 3B > C (1)
B − 3C < C (2)

 These two together imply that:

3B < B − C < 3C

 The gain from signaling must be higher than the cost for high ability types, but not so high that low ability types
are also motivated to signal

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 signaled at all (if none signal, everyone is paid average productivity @ ):
 It is also necessary that for quicks their profit must be higher than what they would get if none of them

B − 3B > G (3)

 This condition is stronger than (1) since G > C : very large α implies that @ is very close to B, making
it more likely that condition (3) cannot be met

 Intuitively: signaling to distinguish is more likely to be profitable for quicks the rarer that they are

 If these conditions are not met, neither has an incentive to obtain the credential, and quicks do not
distinguish themselves from slows (pooling equilibrium): no signaling

 If the conditions are met, quicks signal and slows do not. This is called a separating equilibrium

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WHICH TYPE OF FIRM IS MORE LIKELY TO USE SIGNALING?
 Signaling is helpful
 when employers do not have enough information about job applicants
 when differences in talent among potential employees matter a lot to productivity

 Signaling more important in jobs where skills are most important (at high levels of the hierarchy, in
research and development, and in knowledge work, professional service firms, such as consulting,
accounting, law firms, and investment banks):
 In such professions, small differences in talent can lead to large differences in effectiveness on the job,
so sorting for talent is very important

→ Signaling also more likely to be used where there is not much information already available about job
applicants (e.g. workers who are new to the labor market) although firms can use these techniques even for
hiring experienced talent at very high levels

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