Alleviating adverse selection in labor markets: The wage/pension decision as a signal of worker quality

Vickie L Bajtelsmit, University of Pennsylvania


Adverse selection problems exist in labor contracting when employers are unable to identify worker quality at the outset of the employment relationship. Worker quality, in this context, is the combination of effort and ability that results in particular levels of labor output. Graphical analysis is employed to show that a "separating" equilibrium of the type identified in the insurance literature is possible in a single period context, wherein low quality workers are given an all cash wage commensurate with their quality and high quality workers are able to signal their type by accepting a smaller cash wage plus a deferred pension benefit subject to a vesting requirement that in total is equivalent to their marginal product. However, the long-term context of labor contracting creates multi-period incentive problems which undermine the single period equilibrium outcomes. In a multi-period context, the equilibrium outcome is shown to be a pooled wage/pension first period contract (wherein all starting workers are offered the same contract) and an experience rated second period contract based on information gains in the earlier work period. As in the single period context, the willingness of the high quality workers to accept compensation in the form of deferred pension benefits signals their quality level. Empirical tests matching 1989 IRS Form 5500 pension data with Compustat financial information on plan sponsors confirm a strongly positive relationship between pension generosity and productivity for defined contribution plans. The theoretical and empirical model provide a partial explanation for the nature and variety of wage/pension contracts in existence across and within both firms and industries.

Subject Area

Labor economics|Economic theory|Management

Recommended Citation

Bajtelsmit, Vickie L, "Alleviating adverse selection in labor markets: The wage/pension decision as a signal of worker quality" (1994). Dissertations available from ProQuest. AAI9427495.