The effects of firing costs on the wage contracts under adverse selection

We develop a two-period principal-agent model to investigate the effects of firing costs on self-selection mechanisms and on the optimal wage contracts under adverse selection. There are two types of risk-averse workers who differ by their ability. The worker’s ability is private information but revealed once engaged in production. The adverse selection problem may be solve by workers’ selection from a menu of separating contracts that specifies a sequence of wages with dismissal being the only form of punishment to a worker who overstated his ability. We find that as firing costs increase, the wage-tenure profile of high-ability workers gets steeper while the information rent left to low-ability workers vanishes. For higher levels of firing costs, an incentive menu of contracts provides the most able workers with a lower starting wage than the less able workers. As the expected profit from separating contracts decreases with dismissal costs, there exists a threshold above which the employer prefers to offer a pooling wage that might drive good workers out of the labor market.