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What are some examples of signaling and screening failures or abuses in labor markets?

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Signaling and screening are two concepts in game theory that explain how agents in a market communicate and select information to achieve their goals. In labor markets, signaling and screening are often used by employers and workers to convey and assess their skills, qualifications, preferences, and expectations. However, signaling and screening can also fail or be abused, leading to inefficient or unfair outcomes. In this article, you will learn about some examples of signaling and screening failures or abuses in labor markets and how they affect the parties involved.

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1 Credential inflation

Credential inflation is a phenomenon where the value of a certain degree or certificate declines over time as more people acquire it. This can happen when employers use credentials as a signal of ability or productivity, but the credential does not reflect the actual skills or performance of the workers. As a result, workers may overinvest in education to signal their quality, while employers may face a pool of overqualified or mismatched candidates. Credential inflation can reduce the returns to education, increase the costs of hiring, and create barriers to entry for less-educated workers.

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2 Statistical discrimination

Statistical discrimination is a form of screening where employers use group characteristics, such as race, gender, or age, to infer individual attributes, such as ability, reliability, or productivity. This can happen when employers have limited or imperfect information about the workers, or when they face high costs of acquiring or verifying information. Statistical discrimination can create disadvantages for workers who belong to groups that are stereotyped or stigmatized, and can also reduce the incentives for workers to invest in their human capital or signal their quality.

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Alexander Clark

Data Scientist & Adjunct at Columbia
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"Statistical discrimination" is a term not used to describe discrimination based on immutable characteristics exclusively. Altonji and Pierret (2001), titled "Employer Learning and Statistical Discrimination," also consider screening on education to fall under this category. According to their work, employers statistically discriminate based on education. However, as employers learn, the importance of education falls and harder-to-observe correlates of productivity increase in importance. Your degree matters when you're 22 but not as much if you can find other ways to demonstrate your quality.

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3 Adverse selection

Adverse selection is a problem where the quality of the workers or the jobs in a market is lower than expected, because the parties have asymmetric information and different incentives. This can happen when workers or employers have private information about their own quality, and use it to select the best offers or candidates for themselves, leaving the worse ones for the others. Adverse selection can lead to inefficiencies, such as underemployment, turnover, or mismatch, and can also reduce the trust and cooperation between the parties.

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4 Moral hazard

Moral hazard is a problem where the behavior of the workers or the employers changes after they enter a contract, because they have different interests and face different risks. This can happen when the parties cannot observe or enforce each other's actions, or when the contract does not align the incentives or penalties of the parties. Moral hazard can result in shirking, cheating, or opportunism, and can also reduce the performance or quality of the work.

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5 Signaling games

Signaling games are situations where workers or employers use strategic actions or messages to influence the beliefs or decisions of the other party. These actions or messages can be costly, verifiable, or credible, depending on how they affect the payoffs or reputation of the sender. Signaling games can be beneficial, such as when they reveal hidden information or coordinate expectations, or harmful, such as when they mislead, manipulate, or exploit the receiver. Signaling games can also have multiple equilibria, where the outcomes depend on the beliefs or conventions of the parties.

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6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Haig R. Nalbantian

Co-President/Co-Founder, Workforce Sciences Institute; pioneering Labor/Organizational Economist and Workforce Scientist, well-known authority on Human Capital Measurement and Management, Advanced Workforce Analytics
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Signaling can also occur inside organizations. At Fleet Bank (HBR, "How Fleet Bank Fought Employee Flight") we found supervisor turnover was a major predictor of employee turnover. Was this due to the severance of personal relationships or the information "signal" about the relative value of outside vs. inside opportunity conveyed by the supervisor's decision to leave? To test these alternatives, we examined what happened when the supervisor left the employee but not the bank. We found ZERO turnover effect under such circumstances. The negative signal from the supervisor's exit decision seemed the more likely explanation of the statistical finding. Countering this signal was a big part of Fleet's successful response. Employers take heed.

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What are some examples of signaling and screening failures or abuses in labor markets?

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1 Credential inflation

2 Statistical discrimination

3 Adverse selection

4 Moral hazard

5 Signaling games

6 Here’s what else to consider

Game Theory

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