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to The Quarterly Journal of Economics
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COMPETITION IN SALARIES, CREDENTIALS, AND
SIGNALING PREREQUISITES FOR JOBS *
MICHAEL SPENCE
I. INTRODUCTION
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52 QUARTERLY JOURNAL OF ECONOMICS
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SIGNALING PREREQUISITES FOR JOBS 53
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54 QUARTERLY JOURNAL OF ECONOMICS
III. ASSUMPTIONS
I shall assume that there are identical firms and only two differ-
ent types of people. There is a continuous scalar signal y, which is
purchased by individuals. Each firm has two jobs, indexed by j.
fij (y) = the productivity of a person of type i with the signal
y in job j, in either firm.6
Signals affect productivity as does the individual's type. Produc-
tivity is not affected by the number of others of either type em-
ployed by the firm.7 The proportion of people of type i is qj, i= 1,2.
The second group, i=2, is assumed to be the more productive in the
following sense. In job 1, the lower skilled one,
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SIGNALING PREREQUISITES FOR JOBS 55
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56 QUARTERLY JOURNAL OF ECONOMICS
C, (y)
/f(y)
FIGURE I
PRODUCTIVITIES AND SIGNALING COSTS
away all his employees by raising w, and w2 slightly and still make
a profit.
10. It is this basic property of competitive equilibria that makes the final
outcome inefficient. In M. Spence, "Competitive and Optimal Responses to
Signals: An Analysis of Efficiency and Distribution," Journal of Economic
Theory, VIII (March 1974), 296-332, it is shown that efficiency is achievable;
but usually wages have to deviate from marginal productivities.
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SIGNALING PREREQUISITES FOR JOBS 57
C, (y)
/C2(Y) f2 ( y)
Y)
Yl Y2 Y
FIGURE II
/~~~~f t(Y)
WI~ ~ I
y, Y2 Y
FIGURE III
11. "Efficient" simply means "that which maximizes output net of signal-
ing costs."
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58 QUARTERLY JOURNAL OF ECONOMICS
w
f2( Y)
C, (Y)/
W20 Av-fW (~~~~~~~C?(Y)
w2
,~~~~~~~~~~~~~f ,_ ,
Y. Y2 Y
FIGURE IV
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SIGNALING PREREQUISITES FOR JOBS 59
W Cl (yf
/ BY)
V i m I ~~~(Y)
W2
WI
yI Y2 Y
FIGURE Va
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60 QUARTERLY JOURNAL OF ECONOMICS
W C, (y)
cf2(Y)
f I,(y)
W2t - W y
WI
y
Y.y
Y2 Y
FAGURE Vb
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SIGNALING PREREQUISITES FOR JOBS 61
fc(y)
Y Y, YM Y Y2 Y
FIGURE VI
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62 QUARTERLY JOURNAL OF ECONOMICS
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SIGNALING PREREQUISITES FOR JOBS 63
I want now to return to the possibility that firms may hire only
one type of person. When there is a symmetric equilibrium of type 1,
there is little competitive incentive to specialize. Hence specializa-
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64 QUARTERLY JOURNAL OF ECONOMICS
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SIGNALING PREREQUISITES FOR JOBS 65
X Y Y
FIGURE VII
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66 QUARTERLY JOURNAL OF ECONOMICS
M.Z $ af
The marginal product m~z is assumed to diminish with qqZ. Increases
in y~z increase the marginal products of both groups, but at diminish-
ing rates.
In an equilibrium each group will divide equally over firms.
Otherwise, one firm could profitably expand at the expense of the
others. Wages will equal marginal products (expected or actual
depending upon whether ylZ and y2Z are distinct). And since
firm has to attract both groups to produce, the return to individuals
net of signaling costs must be the same. This fact in conjunction
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SIGNALING PREREQUISITES FOR JOBS 67
with the previous two points implies that the levels of yiZ and Y2Z
must be the same over firms as well. Therefore, we can look for
equilibria by searching for wage schedules for the representative
firm that stand up under competitive pressure. Henceforth, I shall
drop the superscript z.
The problem is to locate pairs (Y1,Y2) (and corresponding wages
that will be equal to marginal products) with the following property:
no other pair attracts both groups and makes a profit. Actually it
is not profits that matter. All that is necessary is that no other
pair with wages equal to marginal products attracts both groups.
The natural way to conduct this search seems to be to depict
the indifference curves of the two groups in the plane with Yi and Y2
on the axes and then simply look for those points, movement from
which reduces the net income of at least one of the groups. The
result is a contract curve, shown in Figure VIII, along with in-
y2
indifference curves
\Y~~~~~~~y
Ye
FIGURE VIII
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68 QUARTERLY JOURNAL OF ECONOMICS
Y2
yI
FIGURE IX
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SIGNALING PREREQUISITES FOR JOBS 69
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70 QUARTERLY JOURNAL OF ECONOMICS
Y2
y~~~~~~~~~~~y
Y. Y.
FIGURE X
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SIGNALING PREREQUISITES FOR JOBS 71
-c2 (Y2) > f'2 (Y2) -c'l (Y2) because c'1 > c'2. The
the slope of the constraint is negative and con
Thus, the minimum occurs at y*1, and the previous argument es-
tablishes that A is the unique candidate for a two-step equilibrium.
Earlier remarks about one-step equilibria are still applicable
and need not be repeated.
Tests and Contingent Contracts
Implicit in the preceding analysis is the concept of an ideal
signal, one that has a zero cost for those who emit it, and a very large
(or perhaps infinite) cost for those who do not. When such signals
are available, they will be used in preference to others in the
active-response case, and they ensure that the equilibrium in the
signaling world duplicates that in the competitive world of perfect
information. Certain kinds of aptitude tests may approximate ideal
signals.
On the other hand, there are several reasons for expecting gen-
eralized potential signals, like education, to carry information. First,
they are productive as well as informative, and it is not easy for
employers to distinguish the effects. Second, because they are produc-
tive, they will be invested in anyway, so that they are available as
signals automatically. Third, because they are generalized signals
for many markets and jobs and because individuals may be uncertain
about the jobs they may ultimately want to have, the lowering or
dropping of an educational prerequisite by a single firm or industry
will not necessarily affect the signal choices of individuals. But if
that is true, then lowering a signaling prerequisite is not a competi-
tive strategy. It is, of course, necessary to assume that firms are
limited in size and range of markets in which they can operate. To
get around this problem, firms and industries would have to act
collectively. But there is little incentive for such collective action,
since in the end it benefits employees. The argument does, of course,
rest upon individual uncertainty about future preferences for vari-
ous kinds of jobs.
I have discussed active responses on the receiving side of the
market. Active responses are possible on the sending side as well.
The principal alternatives to costly signals are contingent contracts.16
The employee agrees to work for a certain salary now, and a fu-
ture salary contingent on the productivity he will be discovered to
have. Explicit contracts of this type are occasionally observed.
Moreover, they may be implicit and common in the salary struc-
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72 QUARTERLY JOURNAL OF ECONOMICS
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SIGNALING PREREQUISITES FOR JOBS 73
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74 QUARTERLY JOURNAL OF ECONOMICS
:> qia
ierP
HARVARD UNIVERSITY
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