Adverse Selection and Wage Gains

The paper shows that for severe enough search frictions, a market for employed workers with wage gains emerges despite the presence of adverse selection. Asymmetric information about a worker's productivity between the worker's current employer and the outside market enables the current employer to keep its best employees from joining the outside market by promoting them or by making them counter offers. Since outside wage offers are uncertain, firms promote or make counter offers only to their best workers. The resulting adverse selection, though, leads to an initial breakdown of the market for employed workers. As lowproductivity workers are laid off over time, tenure serves as a positive signal about a worker's productivity. After enough badly performing workers were laid off, the signal is strong enough to counteract the negative effect of adverse selection and a market for employed workers emerges.