Working Paper: CEPR ID: DP14586
Authors: Ron Kaniel; Dmitry Orlov
Abstract: Adverse selection harms workers, but benefits firms able to identify talent. An informed intermediary expropriates its agents’ ability by threatening to fire and expose them to undervaluation of their skill. An agent’s track record gradually reduces the intermediary’s information advantage. We show that in response, the intermediary starts churning well-performing agents she knows to be less skilled. Despite leading to an accelerated reduction in information advantage, such selectivity boosts profits as retained agents accept below-reservation wages to build a reputation faster. Agents prefer starting their careers working for an intermediary, as benefits from building reputation faster more than offsets expropriation costs. We derive implications of this mechanism for pay-for- performance sensitivity, bonuses, and turnover. Our analysis applies to professions where talent is essential, and performance is publicly observable, such as asset management, legal partnerships, and accounting firms.
Keywords: dynamic signaling; dynamic adverse selection; compensation; career concerns; real options
JEL Codes: No JEL codes provided
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| adverse selection (D82) | impact on workers (F66) |
| adverse selection (D82) | impact on firms (L20) |
| intermediary expropriates agents' abilities (D82) | undervaluation of skills (J24) |
| information asymmetry (D82) | churning decisions (D87) |
| churning (Y60) | profit increase (D33) |
| higher-skilled agents accept lower compensation (J31) | building reputation (M14) |
| pay-for-reputation mechanism (D47) | non-monotonic profit dynamics (C69) |