Informational Externalities in the Labour Market and Their Implications for the Duration of Unemployment
This paper considers a matching model of the labour market where firms can get partial information about workers by testing them prior to hiring them. It is shown that firm's hiring decisions generate several external effects. The first is that by testing the average productivity of workers in the unemployment pool is lowered, which may lead to non-existence of equilibrium. The second is an informational externality; with testing, workers of different ability exit unemployment at different rates, and so unemployment duration is a signal of productivity. It is shown that in equilibrium, firm may wish to condition on duration, only hiring those workers whose duration is below a critical value. Equilibrium is generally inefficient, with too much testing, and too low a critical value for duration.
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