Labor Market Signaling with Overconfident Workers
I extend Spence's (1974) labor market signaling model by assuming some workers are overconfident and some underconfident. Overconfident (underconfident) workers underestimate (overestimate) their marginal cost of acquiring education. Firms cannot observe workers' productive abilities and cannot observe workers' beliefs. However, firms know the fraction of overconfident, underconfident, and high-ability workers in the economy. I find that the presence of overconfident and/or underconfident workers in the labor market compresses wages. I show that workers' biased beliefs reduce welfare when workers are sufficiently different in terms of productivity and cost of education. Finally, I show that if the fraction of overconfident workers is relatively low and workers are sufficiently similar in terms of productivity and cost of education, then biased beliefs improve welfare.
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