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STATISTICAL DISCRIMINATION

IN THE LABOUR MARKET


A DISSERTATION
SUBMITTED TO THE DEPARTMENT OF ECONOMICS
AND THE COMMITTEE ON GRADUATE STUDIES
OF SOUTHAMPTON UNIVERSITY
IN PARTIAL FULFILLMENT OF THE REQUIREMENTS
FOR THE DEGREE OF
DOCTOR OF PHILOSOPHY
Luis Pinedo Caro
June 2013
c _ Copyright by Luis Pinedo Caro 2013
All Rights Reserved
ii
I certify that I have read this dissertation and that, in my opinion, it
is fully adequate in scope and quality as a dissertation for the degree
of Doctor of Philosophy.
(John Knowles) Principal Advisor
I certify that I have read this dissertation and that, in my opinion, it
is fully adequate in scope and quality as a dissertation for the degree
of Doctor of Philosophy.
(...
(Another Department))
I certify that I have read this dissertation and that, in my opinion, it
is fully adequate in scope and quality as a dissertation for the degree
of Doctor of Philosophy.
(...)
Approved for the University Committee on Graduate Studies
iii
Preface
This thesis tells you all you need to know about...
iv
Acknowledgments
I want to thank my supervisor John Knowles for his wisdom and patience.
v
Contents
Preface iv
Acknowledgments v
Introduction 1
1 Double screening in the labour market 3
1.1 Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.1.1 Demographic structure . . . . . . . . . . . . . . . . . . . . . . . 4
1.1.2 Endowments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.1.3 Investment technology . . . . . . . . . . . . . . . . . . . . . . . 4
1.1.4 Production technology . . . . . . . . . . . . . . . . . . . . . . . 4
1.1.5 Detection technology . . . . . . . . . . . . . . . . . . . . . . . . 5
1.1.6 Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.1.7 Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.2 Firms problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.2.1 Prot maximization . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.2.2 Firms constraints . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.3 Workers problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1.4 Nash equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
1.5 Simulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
2 Screening behaviour with n groups 15
2.1 N groups and statistical discrimination . . . . . . . . . . . . . . . . . . 15
2.2 Changes in the baseline model . . . . . . . . . . . . . . . . . . . . . . . 16
2.2.1 Information. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.2.2 Firms problem. . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.3 Solving for the Competitive Equilibrium. . . . . . . . . . . . . . . . . . 17
2.4 Simulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
vi
2.5 Dynamics and rection functions . . . . . . . . . . . . . . . . . . . . . . 19
3 Policy 21
Conclussions 22
A Workers utility maximization problem. 23
B Joint CDF and expected value 25
C Model with perfect information -PI- 27
D Moro & Norman with concave utility 29
D.0.1 Moro & Norman wages . . . . . . . . . . . . . . . . . . . . . . . 29
D.0.2 Dierence with respect FA model . . . . . . . . . . . . . . . . . 30
E Firms Assignment model -FA- 31
F Self-Selection model -SS- 33
G Welfare 35
H Identication procedure in model with 2 races 37
I Toy model of double screening 38
I.1 Utility maximization problem . . . . . . . . . . . . . . . . . . . . . . . 38
I.2 Investment costs and screening variables . . . . . . . . . . . . . . . . . 39
I.3 Firms problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Bibliography 40
vii
List of Tables
1.1 Detection technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.2 Parameters of the economy: . . . . . . . . . . . . . . . . . . . . . . . . 12
G.1 Dierent model specication . . . . . . . . . . . . . . . . . . . . . . . . 35
viii
List of Figures
1.1 Double screening . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
1.2 Firms decisions and human capital access . . . . . . . . . . . . . . . . 13
1.3 Assymmetric vs perfect information: Utility distribution . . . . . . . . 14
2.1 Expected prot when group B is thought to be worse. . . . . . . . . . . 18
2.2 Hiring thresholds for blacks and whites . . . . . . . . . . . . . . . . . . 19
2.3 Firms decisions and human capital access . . . . . . . . . . . . . . . . 19
2.4 Fixed points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
2.5 Convergence of beliefs . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
G.1 Welfare in the labour market: Utility distribution . . . . . . . . . . . . 36
G.2 GDP performance, SS vs FA vs DS . . . . . . . . . . . . . . . . . . . . 36
ix
Introduction
This dissertation studies whether armative action in the form on employment quo-
tas can play an eective role in driving out the impact of statistical discrimination.
In order to model statistical discrimination we use an overlapping generations model
with incomplete information where dierent groups of individuals hold private infor-
mation and rms have a belief regarding how good each of these groups are. Statistical
discrimination may lead to the creation of wage dierentials among otherwise equally
productive workers when prior beliefs regarding productivity dier among groups (i.e.
races) as shown in the theory developed by Arrow (1973, section 4). Arrows theory
started a literature about statistical discrimination modelling followed by Borjas &
Goldberg (1978), Coate & Loury (1993), Moro & Norman (2004) and Blume (2006)
among others, as explained in Fang & Moro (2010)s survey.
In the literature the eects of armative action under statistical discrimination are
investigated by Coate & Loury (1993) and Moro & Norman (2003), although in none
of the models the forecast for the discriminated groups earnings is good. The former
shows that the discriminated group might be patronized by the rms under armative
action and even that armative action might worse the nal outcome once the policy
have stopped. The latter, shows no more hope than the former as armative action
may increase the inequality between groups.
In this study we exploit the essence of both models while adding the possibility
of performance pay. Performance pay is a common feature in high skilled workers
contracts
1
. The latter, under certain conditions, can create a separating equilibrium
able to break the patronizing curse. The purpose of this paper becomes twofold. Firstly
we ask if, under this new setting, an equilibrium where one group is being discriminated,
-pooling-, can be shifted to an equilibrium where both groups are being treated equally,
-separating-, by means of armative action policies. Secondly we look at the eects of
the policies once their application nish.
The reason why armative action may change the nal equilibrium is because the
1
See, for instance, Heywood & Parent (2009)
1
2
impossition of such a policy decreases rms output and may lead the rm to change the
labour prices such that a separating equilibrium is reached. In fact, the imposition of
quotas (armative action) under pooling is less ecient in terms of output than under
truth-telling (i.e. separating). Therefore, whether the reduction in output is of enough
scope so as to justify a change in the equilibrium is the main focal point of this paper.
Two avenues for further research are being also considered. The rst one aims at
generalizing Moro & Norman (2004) general equilibrium model of statistical discrim-
ination with performance pay and explicit rms beliefs. Comparing to the current
paper this generalization would add wages that depend on signals. This allow us to
show a continuum of equilibria where pure pooling (Moro & Normans result) and pure
separation (as explained in this paper) are just two extreme cases. Henceforth rms,
trough the price system, would be indirectly choosing the optimal level of truth-telling.
The second one has to do with an empirical application of statistical discrimination
to explain current wage dierentials.
Literature development
Performance
pay and
Signalling
Endogenous
wages
Exogenous
wages
Signalling
Signals
with
Performance
pay
ex-ante
bunching
Adverse selection
Chapter 1
Double screening in the labour
market
In this chapter we present an overlapping generations model with asymmetric informa-
tion in the labour market. The asymmetry is produced by an employer not knowing
the type of his employees, giving rise to adverse selection. In particular, the principal
cannot distinguish a high skilled worker from an unskilled one. This situation is fol-
lowed by no worker being willing to become high skilled thus leading to an inecient
outcome. The economy, in terms of modelling, has the spirit of Coate & Loury (1993)
although wages are endogenous following Moro & Normans (2004) general equilibrium
model.
A new key feature of the model is the possibility of double screening by the rm.
On the one hand there exists ex-ante screening via the workers signals, as follows from
Coate & Lourys research, where the rationale behind investing is based on workers
expecting a stronger signal after investing in their human capital. On the other hand
we add the possibility for the rm to observe, ex-post, and with some degree of accuracy,
its workers type. The latter opens the door to provide performance pay in order to
incentivize truth telling.
On top of that the model features a continuum of prot maximizing rms, each of
which has measure 0, living in a competitive setting and a continuum of three-period-
lived workers. The description of the model starts with the denition of the enviroment
in which these actors perform their actions and then continues explaining their statregic
interactions. Lastly a denition of equilibrium is provided.
3
CHAPTER 1. DOUBLE SCREENING IN THE LABOUR MARKET 4
1.1 Environment
1.1.1 Demographic structure
There is a continuum of workers born every period with mass normalized to 1. All
workers belong to the same group. The workers lifes is splitted in 3 stages; rst, when
they are young they decide whether to invest in their human capital or not; then, in
their adulthood they work and in the last period of their lifes they quit from their job
and spend the remaining of their income.
1.1.2 Endowments
Every worker of a newly born generation is endowed with one unit of time that is
inelastically supplied to the labour market.
1.1.3 Investment technology
All workers can invest in their human capital and thus become high skilled if they are
willing to assume a disutility . Disutilities are idiosyncratic investment costs following
a truncated normal distribution T A
_

,
l
,
h
_
, with
l
> 0. The eect of
the investment is twofold; in terms of productivity, becoming high skilled entails a
shift in complex tasks productivity from A
l
to A
h
(A
h
> A
l
). But it also oers the
investors higher chances of being well regarded by rms. Workers obtain a signal ,
drawn from the distribution F
h
for investors and from F
l
for non-investors, with F
h
rst-order stochastically dominating F
l
.
Denition We dene the economys investment rate in human capital as the cu-
mulative density up to a given incentive to invest 1
+
. This rate in denoted
= F

(,

,
l
,
h
).
1.1.4 Production technology
Firms have access to a production technology that uses labour to produce output Y .
The technology uses the eciency units of workers carrying out complex C and simple
S tasks. The production function is a mapping Y : 1
2
+
1 represented by a CES
function.
Y = A[C

+ (1 )S

]
1/
(1.1)
CHAPTER 1. DOUBLE SCREENING IN THE LABOUR MARKET 5
Where A stands for the total factor productivity and is the income share asso-
ciated to the complex task. In addition determines the degree of substitutability
between eciency units at each task. The production function also fullls the Inada
conditions. The eciency units add up the number of workers times the respective
productivities. Workers in the simple task are assumed to produce the same regardless
of their background. On the contrary high skilled H workers do better the complex
tasks.
C = A
h
H
c
+A
l
L
c
(1.2)
S = H
s
+L
s
(1.3)
1.1.5 Detection technology
After the tasks have been carried out, rms detect whether a worker is high or low
skilled with a certain degree of accuracy. The probability of a high skilled of being
detected as such is normalized to 1. On the contrary, the probability of a low skilled
being mismatched as a high skilled is idiosyncratic to each low skilled worker and is
distributed truncated normal TN(

,
l
,
h
).
Observed
H L
R
e
a
l
H 1 0
L 1
Table 1.1: Detection technology
The probabilities of fooling the rm are randomly drawn right after a non-investor
is oered a job dealing with complex tasks. The rationale is that a worker only gets to
know his chances of fooling a particular rm once he is inside.
1.1.6 Preferences
Workers have a discounted preference over consumption when they are adults and old.
The utility given by the consumption of goods is represented by an isoelastic utility
function u(c) =
c
1
1
. It is assumed consumption when they are old might be uncertain
and take over two states, high, with probability q and low, with probability (1 q).
CHAPTER 1. DOUBLE SCREENING IN THE LABOUR MARKET 6
Therefore, the lifetime utility, assumed to be additive separable, becomes:
U
_
c
a
, c
o,h
, c
o,l
_
=
c
a
1
1
1
+
_
q
c
o,h
1
1
1
+ (1 q)
c
o,l
1
1
1
_
I() (1.4)
and the utility function (net of investment costs) evaluated at the optimum is denoted
as
V = U(c
a

, c
o,h

, c
o,l

) (1.5)
where (0, 1) is the discount factor and is the coecient of relative risk aversion.
In addition c
a
and c
o
are, respectively, consumption levels when the worker is an adult
and when he gets old. The indicator function I() takes the value 1 when the worker
has invested in his human capital. Also note that, for simplicity, the cost of investing
in human capital enters linearly the lifetime utility function.
1.1.7 Information
Some information is publicly known. The rms announcement on wages, the hiring
threshold and the workers signals
i
.
Workers information
Workers privately know the disutility for investing in their human capital,
i
, and their
chance to fool the employer
i
. The former is known as soon as they are born, the
latter once they get to know their workplace (after investment has taken place).
Firms information
Firms know the workers cost and fooling probabilities cumulative distribution func-
tions although they cannot observe the type of an individual worker, (
i
,
i
). Firms, in
addition, use the signal to obtain the posterior probability of having invested as follows:
p() =
f
h
()
f
h
() + (1 )f
l
()
(1.6)
1.2 Firms problem
The productive sector of the economy is made of a continuum of rms, each of measure 0
producing a composite good. Because there exists a large number of rms producing the
same homogeneous good we assume they operate under perfect competition. From now
CHAPTER 1. DOUBLE SCREENING IN THE LABOUR MARKET 7
on, and without loss of generality since the information and the technology available to
each of these rms is identical, we examine the behaviour of a representative rm.
First of all, the rm oer a menu of contracts for the workers to choose upon. These
contracs take the following form:
Denition A contract w
a
(), w
o
(

I) is an agreement between the worker and the rm


by which the rm oers two payments, one ex-ante that depends on the signal, and one
ex-post, that depends on the detected
1
performance

I.
Contracts oered to workers doing simple tasks are normalized such that w
o
= 0
and w
a
() = w
s
, as their productivity is known from the beginning. On the contrary,
workers doing complex tasks are oered an unconditional payment w
a
() = p()w
c
based on the posterior plus a perfomance payment conditioned on being declared high
skilled w
o
= w
p
[

I = 1. The rationale on how to use the performance pay is simple,


the rm will set a relatively high performance pay with an also relatively high wage to
workers doing simple tasks so as to disincentivize potential foolers.
In addition to the contracts the rm sets a hiring threshold,

(, ), repre-
senting the signal upon which workers are given a chance to perform complex tasks.
The timing of announcement of contracts and thresholds is crucial; before the workers
investment decisions take place the rm will set and announce
2
contracts for complex
task workers p()w
c
, w
p
[

I = 1, simple task workers w


s
, 0 and the hiring threshold

.
Finally it is worth explaining how competition aects
3
our representative rm
choices.
Denition The outside value of a worker, denoted

U, is dened as the utility a worker
could achieve by putting his services back in the market.
It follows from the denition of outside value that workers needs to be oered at least,
as much they could get elsewhere. That value is denoted

U
s
for workers oered to
perform simple tasks and

U
c
to workers oered to do complex tasks.
1
The performance pay does not depend on the signal as no new information arises from the union
of the detected performance and the signal.
2
In addition it is in the best interest of the rm to respect the contracts since any deviation would
yield a worse outcome.
3
That is an abstraction exercise since having only rm cannot lead to competition of any kind, but
the logic follows in our original setup on many small rms.
CHAPTER 1. DOUBLE SCREENING IN THE LABOUR MARKET 8
1.2.1 Prot maximization
The objective of the representative rm is to maximize its prot. The rm, thus,
chooses wages and a hiring threshold to maximize the following function:
Max

,w
c
,w
p
,w
s
P = Y E[p()]w
c
N
c
w
p
(H
c
+L
c
E[[D = 1]) w
s
N
s
(1.7)
Where it should be noted performance pay w
p
is given to all high skilled in the
complex task plus to those who succesfully managed to deceive (D) the rm. The inner
shape of the production function is:
Y = A[C

+ (1 )S

]
1/
(1.8)
where C = A
h
H
c
+ A
l
L
c
and S = H
s
+ L
s
represent the eciency units at each task.
The heads count of workers doing complex tasks is the proportion of expected investors
and non-investors (1 ) willing to remain doing complex tasks, times the probability
of being assigned to these tasks. The same logic applies to the number of workers doing
simple tasks.
N
c
= H
c
+L
c
= [1 F
h
(

)] + [1 F
l
(

)](1 )F
D
(1.9)
N
s
= H
s
+L
s
= F
h
(

) +F
l
(

)(1 ) + [1 F
l
(

)](1 )[1 F
D
] (1.10)
where F
D
is the proportion of low skilled workers oered a complex task that deceive
the rm and try to fool it.
1.2.2 Firms constraints
The maximization program of the rm is constrained by two Individual Rationality
constraints and two Incentive Compatibility constraints. The two IR constraints reect
that the rm must oer at least the market utility for a worker to choose that rm as
his workplace, i.e. it is an ex-ante constraint.

U
H
[1 F
h
(

)]V
h,c
E
+F
h
(

)V
s
IR.H (1.11)

U
L
[1 F
l
(

)]V
l,c
E
F
D
+ [1 F
l
(

)]V
s
[1 F
D
] +F
l
(

)V
s
IR.L (1.12)
CHAPTER 1. DOUBLE SCREENING IN THE LABOUR MARKET 9
On the other hand, the two IC constraints state the conditions upon which workers
will not pretend to be a dierent type inside the rm. These constraints are aimed at
workers who are given the chance to do complex tasks. Workers assigned to do simple
tasks have no choice. These ex-post constraints work in two directions: Firstly the
IC.H makes sure high skilled individuals do not pretend to be low skilled and do simple
tasks. Then, the IC.L states how many low skilled workers are deterred to deceive the
rm. Those with low enough signals and fooling probabilities will reveal their type.
V
h,c
V
s
IC.H (1.13)
V
s
V
l,c
(, ), for some (, ) IC.L (1.14)
Note the importance of the IC.L constraint is in the growing cost of separation (i.e.
making all potential foolers to reveal their type would imply V
h,c
= V
s
and no worker
would invest).
1.3 Workers problem
Workers take two decisions during their life; First they decide whether to become high
skilled or not. Then, after they have entered a rm, low skilled workers given a chance
to do complex tasks decide whether to deceive his employer or not.
A new generation
0
is born
decision
Investment
Fooling
1
decision
Workers
consume c
a
Look-alike
2
investors
receive w
p
Workers
consume c
o
The generation
3
dies
Value function: To explain these decisions we need to know how they value the
contracts oered by the rm. Given a contract (w
a
(), w
o
) and a probability q
4
of
obtaining w
o
, the workers indirect utility is given by
V (w
a
(), w
o
, q) = Max
c
a
,c
o,h
,c
o,l
U. (1.15)
4
Note q = 1 for a high skilled worker doing complex tasks.
CHAPTER 1. DOUBLE SCREENING IN THE LABOUR MARKET 10
where we assume workers face liquidity
5
constraints.
Low skilled doing complex tasks. After the realization of their fooling probabilities

i
and knowing their signal
i
, low skilled workers compare the utility they would get
by revealing their type and doing simple tasks (D=0, no deceive) and the expected
conditional utility if they stay doing complex tasks (D=1, deceive).
E[U[D = 1] = V
l,c
E
(p(
i
)w
c
, w
p
,
i
) (1.16)
E[U[D = 0] = V
s
(w
s
, 0) (1.17)
the incentive to fool the rm is
= E[U[D = 1] E[U[D = 0] (1.18)
We can dene the function that relates signals and fooling probabilities such that a
worker will accept a complex task. This probability is computed as

i
=
_
V
s
V
l,c
E
(p(
i
)w
c
, w
p
)
_
(1.19)
therefore workers with combinations of (
i
,
i
) such that V
l,c
E
> V
s
will attempt to fool
the rm (D=1) and do complex tasks. The amount of workers deceiving is given by
the joint CDF of the signals for low skilled and the fooling probabilities denoted F
D
.
F
D
is calculated as:
F
D
=
_

max

min
_

max

min
()
f
l
(,

, )f

(,
l
,
h
)dd (1.20)
In addition we calculate the expected probability of fooling given deceive E[[D = 1]
as:
E[[D = 1] =
_

max

min
_

max

min
()
f
l
(,
min
, )f

(,
min
,
h
)dd (1.21)
Note in the last equation that the lower truncation of f

is moving with
min
.
5
See the appendix for the complete development of the maximization problem.
CHAPTER 1. DOUBLE SCREENING IN THE LABOUR MARKET 11
Investment decisions. Individuals makes decisions on their human capital as soon
as they know their investment costs. A worker compares the expected utility of invest-
ing and not investing. Given information on wages and the hiring threshold workers
calculate the incentive to invest. This is done by weighting all the potential utilities by
their respective probabilities.
E[U[I = 1] = [1 F
h
(

)]V
h,c
E
+F
h
(

)V
s
(1.22)
E[U[I = 0] = [1 F
l
(

)]V
l,c
E
F
D
+ [1 F
l
(

)]V
s
[1 F
D
] +F
l
(

)V
s
(1.23)
the incentive to invest is dened as
= E[U[I = 1] E[U[I = 0] (1.24)
and workers with
i
< decide to invest I = 1. The investment rate is thus calculated
by evaluating the incentive to invest in F

which gives us the percentage of investors


in the economy = F

().
CHAPTER 1. DOUBLE SCREENING IN THE LABOUR MARKET 12
1.4 Nash equilibrium
Denition Allocations c
a,i
, c
o,i
i (0, 1), workers strategies

I
i
,

D
i
i (0, 1),
rms strategies

, outside values

U
H
,

U
L
and wages w
c
, w
p
, w
s
constitute a Nash
equilibrium if they are such that:
i Given market outside values

U
H
,

U
L
, rms strategies

and wages w
c
, w
p
, w
s

solve the rms problem:


ii i (0, 1), given rms strategies

and wages w
c
, w
p
, w
s
, workers strategies

I
i
solve the workers investment decisions:
iii i (0, 1), given rms strategies

and wages w
c
, w
p
, w
s
, workers strategies

D
i
solve the workers deceiving decisions:
iv All markets clear.
1.5 Simulation
We simulate the economy with the following parameters with respect the preferences
and the available productive technology:
Table 1.2: Parameters of the economy:
Exogenous Value Meaning
parameters
0.6 Discount factor
0.99 Intertemporal substitution
A 10 Aggregate level of the technology
A
h
1 High skilled productivity doing complex tasks
A
l
0.5 Low skilled productivity doing simple tasks
0 Substitution coecient between tasks
0.5 Complex tasks share in output
The rst gure remarks the trade-o between two competing screening mechanisms,
signals and incentives for truth-telling.
Conclussions:
CHAPTER 1. DOUBLE SCREENING IN THE LABOUR MARKET 13
Figure 1.1: Double screening
0
1
F
l
Dif in mean between Fh and Fl
Screening usage: Low skilled detection as signals improve


0 2 8 10
0
1
1F
D
Caught by the firm
Selfincriminated
Figure 1.2: Firms decisions and human capital access
0 0.2 0.4 0.6 0.8 1 1.2 1.4
2.5
3
3.5
4
4.5
5
5.5
6
6.5
7
7.5
Salaries depending on investment costs
Mean of investment costs distribution
S
a
l
a
r
i
e
s


w
c
w
p
w
s
0 0.2 0.4 0.6 0.8 1 1.2 1.4
0.5
0
0.5
1
1.5
Screening usage, thresholds
Mean of investment costs distribution

CHAPTER 1. DOUBLE SCREENING IN THE LABOUR MARKET 14


Figure 1.3: Assymmetric vs perfect information: Utility distribution
2 1 0 1 2 3
0
0.5
1
1.5
2
2.5
3
Utility spreaded over investment cost
Investment cost
U
t
i
l
i
t
y


Assymmetric information
Perfect information
Remaining low skilled workers should be happier if the investment cost are lower
(easier access to education).
There is a trade-o between the screenings procedures.
3 dierent screening usage, only signalling, only detection technology, both sig-
nalling and detection technology.
Everyone is happier for having less investment costs.
Low skilled and high skilled workers achieve similar utility in the beginning of
their working lifes, but high skilled are much better later on.
The more useless are low skilled in complex tasks the more the rm uses signalling,
contrary to detection.
Chapter 2
Screening behaviour with n groups
2.1 N groups and statistical discrimination
In this chapter we generalize the model presented in chapter one by giving space to
the co-existence of several groups. These groups have a characteristic that makes their
identication from each other inmmediate (i.e. skin colour). We add this feature
because under some conditions, the presence of dierent groups in an economy with
informational assymmetries may lead to statistical discrimination.
Statistical discrimination is, alongside taste for discrimination, one of the prevailing
explanations for treating individuals with similar skills in dierent ways. As a theory,
statistical discrimination is based on a principal whose beliefs with regards certain
groups do not reect the reality, meaning a negative bias arises towards the group(s)
that generated less favourable beliefs.
The appearance of statistical discrimination in an economy has 2 consequences; On
the one hand generates allocative ineciencies in the economy. On the other hand
a negative belief may become a self-fullling prophecy converting statistical discrimi-
nation into rational behaviour. It is with regards to the latter that this model, and
contrary to other authors research, might escape from the self-fulfulling prophecy trap
and predicts convergence in workers earnings even though this convergence is not in-
mediate.
The addition of dierent groups in the economy require us to slightly modify the
environment of the economy. That includes modifying the demographic structure and
specifying the beliefs rms hold about each group. Then we state the rms new
maximization problem and the conditions under which statistical discrimation arises.
15
CHAPTER 2. SCREENING BEHAVIOUR WITH N GROUPS 16
2.2 Changes in the baseline model
Now the economy is populated by n groups, each with size
j
for j (1, n), j N. The
addition of several groups has an eect on the decision making of the rms.
2.2.1 Information.
On the one hand rms hold a belief for each group in the economy regarding the mean
of the cost distribution,
j

. These beliefs might dier from each other. The relationship


between the dierent beliefs may cause some groups to face a disadvantage with respect
to other. These sets of beliefs are called discriminatory beliefs.
Denition We dene a discriminatory belief as a set of rms beliefs such that
j

>
j

for some j and


k

=
k

for all k ,= j.
2.2.2 Firms problem.
On the other hand the rms maximization problem needs to be revisited. The rm
now might choose dierent hiring thresholds for each group

j
. Note we assume the
existence of an equal pay act that constrains the rm to pay the same wage to workers
sharing the same signal and doing the same task.
Given

U
H,j
,

U
L,j

n
j=1
, j N, the representative rm chooses hiring thresholds

j
and wages to maximize:
Max

j
,w
c
,w
p
,w
s
P = Y w
c
_

j
E
j
I
[p()]H
c,j
+

j
E
j
N
[p()]L
c,j
_
w
p
_
H
c
+

j
L
c,j
E
j
[[D = 1]
_
w
s
N
s
(2.1)
where the main dierence is in the way we add up the number of workers at each task.
We treat workers labour from dierent groups as being perfect substitutes.
N
c
=
n

j=1

j

j
[1 F
h
(

j
)] +
n

j=1

j
[1 F
j
D
](1
j
)[1 F
l
(

j
)] (2.2)
N
s
=
n

j=1

j

j
F
h
(

j
) +
n

j=1

j
(1
j
)F
l
(

j
) +
n

j=1

j
F
j
D
(1
j
)[1 F
l
(

j
)] (2.3)
Note dierent hiring thresholds will now restrict the access to perform complex tasks
for certain groups. Finally, the rms choice of dierent hiring thresholds for each group
CHAPTER 2. SCREENING BEHAVIOUR WITH N GROUPS 17
produces the existence of 2 n Individual Rationality constraints. For all j (1, n) we
have

U
H,j
[1 F
h
(

j
)]V
h,c
+F
h
(

j
)V
s
IR.H
j
(2.4)

U
L,j
[1 F
l
(

j
)]V
l,c
E
F
j
D
+ [1 F
l
(

j
)]V
s
[1 F
j
D
] +F
l
(

j
)V
s
IR.L
j
(2.5)
On the other hand, we also have 2 n IC constraints stating the conditions upon
which workers will not pretend to be a dierent type inside the rm. These constraints
are aimed at workers who are given the chance to do complex tasks. Workers assigned
to do simple tasks have no choice. These ex-post constraints work in two directions:
Firstly the IC.H make sure high skilled individuals do not pretend to be low skilled and
do simple tasks. Then the IC.L states the degree of separation of the economy. Those
with a high enough combination of signals and fooling probabilities will give it a shot.
V
h,c
(

j
) V
s
IC.H
j
(2.6)
V
s
V
l,c
(, ), for some (, ) IC.L
j
(2.7)
Note the importance of the IC.L constraint is in the growing cost of separation (i.e.
making all potential foolers to reveal their type would imply V
h,c
(, ) = V
s
and no
worker would invest).
Proposition 2.2.1 When paired, a discriminatory belief and the prot maximizing
behaviour of the rm give rise to statistical discrimination.
2.3 Solving for the Competitive Equilibrium.
We process to nd the competitive equilibrium of this economy works as follows:
Find the equilibrium outside utilities for high skilled under a non-discriminatory
belief

B
=

W
.
For any

B
>

W
nd the expected prot under the old outside values.
If the expected prot found is positive shift

U
H,W
up until prot becomes 0. If
the prot is negative shift

U
H,B
up until prot becomes 0.
The new pair

U
H,W
,

U
H,B
is the new equilibrium pair.
CHAPTER 2. SCREENING BEHAVIOUR WITH N GROUPS 18
2.4 Simulation
We simulate the competitive equilibrium for a 2 group economy j B, W for a range
of B group rms beliefs
B

(0.8, 1.3) while normalizing the belief for the W group



W

= 0.8. That means the rm always believe group B members have, on average, a
higher cost of investing in their human capital.
In the rst graph we see the expected prot of the rm out of equilibrium. Given a
pair of outside values

U
h,w
,

U
h,b
obtained in equilibrium under a non-discriminatory
belief we compute again the economy just adding a negative rms belief towards the
B group. We see the expected prot is not always negative. It turns out that for cer-
tain parameterizations the rms ability to select dierent screening levels for dierent
groups outweigths the -expected- higher investment costs of certain workers.
Figure 2.1: Expected prot when group B is thought to be worse.
0.8 0.95 1.15 1.3
0.1
0.05
0
0.05
0.1

B
E
x
p
e
c
t
e
d

P
r
o
f
i
t
Expected profit under raceblind eq outside values


A
l
=0
A
l
=0.5
The second graph shows equilibrium behaviour of a representative rm under dif-
ferent beliefs for the B group. The rm is setting a more restrictive hiring threshold
to the W group while it allows for a comparatevly looser threshold for group B when
the belief toward the B group becomes more negative. The rm is giving workers from
an -ex-ante- believed better group a harder time joining the complex task. Why would
the rm do that?
What the rm is actually doing is swaping the screening methods for the whites as
we see in the two graphs below. It holds the screening usage for blacks while relying
on assingment rather than on self-selection for whites. The rationale is as follows, the
CHAPTER 2. SCREENING BEHAVIOUR WITH N GROUPS 19
Figure 2.2: Hiring thresholds for blacks and whites
0.8 0.9 1 1.1 1.2 1.3
0
0.4
0.8
1.2
Firms belief towards the B group,

B
.
H
i
r
i
n
g

t
h
r
e
s
h
o
l
d
s

W
,

B


Hiring threshold for W
Hiring threshold for B
Figure 2.3: Firms decisions and human capital access
0 0.15 0.35 0.5
0
0.3
0.7
1
F
l
Dif in mean between F

B
and F

W
Screening usage: Whites low skilled detection.


0 0.15 0.35 0.5
0
0.3
0.7
1
1F
D
Selfselected
Assigned by the firm
0 0.15 0.35 0.5
0
0.3
0.7
1
F
l
Dif in mean between F

B
and F

W
Screening usage: Blacks low skilled detection.


0 0.15 0.35 0.5
0
0.3
0.7
1
1F
D
Selfselected
Assigned by the firm
rm is not worried about whites deceiving, in any case most of them are good, but
it is particularly cautious with the blacks as their group is expected to invest less.
Therefore, even though most blacks are oered a position in the complex task few of
them are expected to accept it.
2.5 Dynamics and rection functions
CHAPTER 2. SCREENING BEHAVIOUR WITH N GROUPS 20
Figure 2.4: Fixed points
0 0.2 0.4 0.6 0.8 1
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1

Fixed point and reaction function for FA and DS




Only Signalling
Double Screening
45 degree line
Figure 2.5: Convergence of beliefs
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1

W
,
B

B


B group RF
W group RF
45 degree line
Convergence Zone
Divergence Zone
FA model
DS model
Chapter 3
Policy
Policies:
No equal wage act. w
c,w
, w
p,w
, w
c,b
, w
p,b
, w
s,w
, w
s,b
.
Quotas
w
=
b
and the like.
Subsidy to perfomance pay wages.
21
Conclussions
...
22
Appendix A
Workers utility maximization
problem.
Under certain payments
The utility obtained by high skilled workers (w
1
= w
c
, w
2
= w
p
) in the complex task
and any worker in the simple task (w
1
= w
s
, w
2
= 0) is known ex-ante, given wages.
To solve for the optimal allocations workers need to maximize the following function:
Max U (c
a
, c
o
) =
c
a
1
1
1
+
c
o
1
1
1
(A.1)
subject to
c
a
w
1
(A.2)
c
a
+c
o
= w
1
+w
2
(A.3)
The utility function evaluated at the optimum takes two values:
V =
_

_
w
1
1
1
1
+
w
2
1
1
1
if w
1

w
1
+w
2
1+
1/

w
1
+w
2
1+
1/

1
1
1
+

w
1
+w
2
1+
1/

1
1
1
if w
1
>
w
1
+w
2
1+
1/
(A.4)
Under uncertain payments
If the performance pay is uncertain, as it happen to the low skilled workers when joining
the complex task, some precautionary savings will be taken in order to insure themselves
against the risk of not having anything when they are old. The maximization program
23
APPENDIX A. WORKERS UTILITY MAXIMIZATION PROBLEM. 24
is:
Max U
_
c
a
, c
o,h
, c
o,l
_
=
c
a
1
1
1
+
_

c
o,h
1
1
1
+ (1 )
c
o,l
1
1
1
_
(A.5)
subject to
c
o,h
= w
c
+w
p
c
a
(A.6)
c
o,l
= w
c
c
a
(A.7)
The value function analytical expression is not easy to nd so we provide, on the
one hand, the rst order condition that gives the optimum:
c
a

=
_
(w
c
+w
p
c
a
)

+ (1 )(w
c
c
a
)

_
(A.8)
Once c
a
is known we can pin down future consumption using the constraints of the
problem. The value function is the utility function evaluated at the optimum V =
U(c
a

, c
o,h

, c
o,l

).
Appendix B
Joint CDF and expected value
In chapter 1 the model developed needs to calculate the joint CDF of two disjoint
truncated normal random variables and the expected value of one of the variables.
With regards to the former the joint CDF is dened as:
F
D
=
_

max

min
_

max

min
()
f
l
(,

, )f

(,
l
,
h
)dd (B.1)
but a word must be said about the integration limits. The upper limits of both integrals
are given by the high end of both truncated normal distributions i.e.
max
=
1
,

max
=
h
. On the contrary the lower bounds calculation is more subtle. On the one
hand the lower bound of the outer integral
min
might depend on the higher bound of
the inner integral
max
as follows
2
:

min
= max
_
V
s
(V
l,c
(
max
))
1
,

_
(B.2)
On the other hand the lower bound of the inner integral depends on the outer vari-
able. The idea is that we must ensure the pairs , satisfy the incentive compatibility
constraint for a low skilled to accept a complex task.

min
=
V
s
(V
l,c
())
1
(B.3)
In addition we calculate the expected probability of fooling given a worker deceives
1
f
l
is not truncated from above
2
Provided the inverse of V
l,c
exists.
25
APPENDIX B. JOINT CDF AND EXPECTED VALUE 26
E[[D = 1] as:
E[[D = 1] =
_

max

min
_

max

min
()
f
l
(,
min
, )f

(,
min
,
h
)dd (B.4)
where it has to be noted, in addition to what was explained before, that the lower
truncation of the distributions follows the lower bounds of the respectives integrals.
This is because we must ensure the volume adds up to one. In addition the order of
integration (rst , then ) is not trivial; Since the signal occurs rst in time, we need
to know what probabilities of fooling are IC and not vice-versa.
Appendix C
Model with perfect information -PI-
Here we work out the details of the model presented in chapter 1, if the rms were able
to tell whether a worker has invested in his human capital straight away. That clears
out the informational asymmetry from the model and also a source of inneciency. The
maximization problem that the representative rm faces varies slightly. In particular
note the rm does not choose hiring thresholds, nor it worries about the low skilled
workers potentially doing complex tasks as there are no deceivers. In addition we
simplify the model further by eliminating the performance payment w
p
, because the
rm knows ex-ante the performance of every worker and there is no reason to withhold
payments.
Max
w
c
,w
s
P = Y w
c
N
c
w
s
N
s
(C.1)
The production function reects the change in the available information:
Y = A[(A
h
N
c
)

+ (1 )(N
s
)

]
1/
(C.2)
Where all workers doing complex tasks have productivity A
h
(all invested). The heads
count of workers doing complex tasks is just the amount of expected investors while for
simple tasks is the amount of non-investors.
N
c
= (C.3)
N
s
= (1 ) (C.4)
27
APPENDIX C. MODEL WITH PERFECT INFORMATION -PI- 28
Constraints There are also changes with regards to the rms constraints. Both
Incentive Compatibility constraint are now missing in action because workers cannot
pretend there are a dierent type. We are left with the 2 Individual rationality con-
straints:

U
H
V
h,c
IR.H (C.5)

U
L
V
s
IR.L (C.6)
Appendix D
Moro & Norman with concave
utility
This model replicates a special version of Moro & Normans signalling model. Contrary
to our approach, they assume the base wages wages w
c
, w
s
are equal to the marginal
products
Y
C
,
Y
S
. Since paying the marginal product entails 0 prot the problem sim-
plies to an output maximization problem where the choice variables are and the
hiring threshold

.
Max
,

Y = A[C

+ (1 )S

]
1/
(D.1)
where the eciency units are given by
C = A
h
[1 F
h
(

)] +A
l
(1 )[1 F
l

)] (D.2)
S = F
h
(

) + (1 )F
l
(

) (D.3)
where the investment rate is given by = F

() as before. We need to add an Incentive


Compatibility constraint for high skilled
V
h,c
(

) V
s
IC.L (D.4)
D.0.1 Moro & Norman wages
The marginal products for the complex and the simple tasks are:
MP
s
=
A

(C

+ (1 )S

)
1

(1 )S
1
; (D.5)
29
APPENDIX D. MORO & NORMAN WITH CONCAVE UTILITY 30
MP
c
=
A

(C

+ (1 )S

)
1

C
1
; (D.6)
and the wages actually paid to the workers performing each fo the tasks are p(, )w
c
, 0
for the complex task and w
s
, 0 for those doing simple tasks.
D.0.2 Dierence with respect FA model
We do not have Individual Rationality constraints as we do in the FA model. That is
because zero prot is automatically achieved when assuming the rm is paying out the
marginal products. Still we can compute the outside utilities as follows:

U
H
= [1 F
h
]V
h,c
E
+F
h
V
s
(D.7)

U
L
= [1 F
l
]V
l,c
E
+F
l
V
s
(D.8)
Appendix E
Firms Assignment model -FA-
The idea of this section is to collapse the model of double screening to a particular
version of the signalling model used by Moro & Norman (2003). We delete the detection
tecnology from the environment even though utility is still convex. We maintain the
convex utility function as it is not a crucial feature of Moro & Normans signalling
model and it allows for welfare comparisons among models of the same class.
Firms problem No detection technology means no new information is obtained afer
the tasks have been carried out. If all the relevant information is obtained ex-ante there
is no need for an ex-post payment and so the rm chooses upon a payment for complex
task workers w
c
, simple task workers w
s
and a hiring threshold

.
Max
w
c
,w
s
,

P = Y w
c
(E[p
I
()H
c
+E[p
N
()L
c
]) w
s
N
s
(E.1)
The production function is as dened in the environment of the economy:
Y = A[(A
h
H
c
+A
l
L
c
)

+ (1 )(N
s
)

]
1/
(E.2)
Where workers doing complex tasks have dierent producivities depending on their
investment decisions. The heads count of workers doing complex tasks eliminates the
self-selection shown in the main model. Now all workers who are oered to do a complex
task will accept.
N
c
= [1 F
h
] + (1 )[1 F
l
] (E.3)
N
s
= F
h
+ (1 )F
l
(E.4)
31
APPENDIX E. FIRMS ASSIGNMENT MODEL -FA- 32
Constraints With regards to the Individial Rationality constraints no dierence is
shown apart from what arises as a result of the performance pay deletion.

U
H
[1 F
h
]V
h,c
E
+F
h
V
s
IR.H (E.5)

U
L
[1 F
l
]V
l,c
E
+F
l
V
s
IR.L (E.6)
But an important change occurs in the Incentive Compatibility constraints. Since
now there is no way to prevent low skilled workers with signals above the threshold
from deceiving the rm IC.L is always broken.
V
h,c
V
s
IC.H (E.7)
V
s
V
l,c
IC.L Broken! (E.8)
IC.L is broken for all >

as a direct result of IC.H being impossed. The latter implies
a pure pooling equilibrium.
Appendix F
Self-Selection model -SS-
This appendix describes an economy with adverse selection. For the rm to succesfuly
screen the workers it needs a variable that is correlated with workers productivity. In
this case the rm knows, after output has been realiazed, and with a certain degree of
accuracy, whether the worker invested in his human capital or not.
Contrary to the model of Firms Assingment -FA- the rm does not observe any sig-
nal positively correlated with workers investment decision when they join the company.
Still, the rm might set a hiring threshold if the detection technology is too weak.
Max

,w
c
,w
p
,w
s
P = Y w
c
N
c
w
p
(H
c
+E[[D = 1]L
c
) w
s
N
s
(F.1)
The production function is the standard one:
Y = A[C

+ (1 )S

]
1/
(F.2)
Note now

(0, 1). The eciency units are given by:
C =

+ (1 )

[1 F

( )] (F.3)
S = (1

) + (1 )()1

+ (1 )

( ) (F.4)
Constraints: Finally we need to dene 2 individual rationality and 2 incentive com-
patibility constraints. With regards to the Individial Rationality constraints no dier-
ence is shown apart from what arises as a result of the performance pay deletion.

U
H


V
h,c
+ (1

)V
s
IR.H (F.5)
33
APPENDIX F. SELF-SELECTION MODEL -SS- 34

U
L


V
l,c
E
[1 F

( )] +

V
s
F

( ) + (1

)V
s
IR.L (F.6)
A key dierence arises on the IC.L constraint compared to the FA model. The IC.L
constraint is not broken for a certain subset of the low skilled workers invited to perform
complex tasks and, therefore, some will refuse to carry them out.
V
h,c
V
s
IC.H (F.7)
V
s
= V
l,c
( ) IC.L (F.8)
The IC.L holds for all < meaning there will be a semi-separating equilibrium.
Appendix G
Welfare
Here we compare a godesque rm that knows the type of each worker with a range of
models specication featuring performance pay and signalling:
1. Firms Assingment -FA-, when the model only use signals.
2. Self Selection -SS-, when performance pay deter foolers.
3. Double screening with ex-ante at wage -DSat-, because w
a
() = w
c
.
4. Double Screening -DS-, combining signals and performance pay.
The characteristics of each of the specications is summarized in the table below:
Features
Signals w
c
() Perf. pay
M
o
d
e
l
s
FA
SS
DS-at
DS
Table G.1: Dierent model specication
On the one hand we focus on the welfare distribution sorted by investment cost.
Another measure of welfare is GDP. In the next graph we show GDP in each model
for dierent signals quality and dierent detection technologys quality.
35
APPENDIX G. WELFARE 36
Figure G.1: Welfare in the labour market: Utility distribution
2 1 0 1 2 3
0
0.5
1
1.5
2
2.5
3
3.5
Utility spreaded over investment cost
Investment cost
U
t
i
l
i
t
y


Double Screening
Perfect information
Firms Assingment
SelfSelection
Figure G.2: GDP performance, SS vs FA vs DS
Appendix H
Identication procedure in model
with 2 races
There is an identication problem when solving for competitive equilibrium whenever
there is more than 1 group. Even after we get rid of the IR constraints for low skilled
1
we still have to iterate two numbers

U
H,w
,

U
H,b
until expected prot is 0. How? Who
we are to decide some will recive more than other...!?
Idea for computing competitive equilibrium:
We have, in principle 4 IR constraints: IR.L
w
, IR.H
w
, IR.L
b
and IR.H
b
. We know
2 of them do not bind, IRLs. From the IRHs we have:

U
H,w

w
V
h,c
+ (1
w
)V
s
IR.H
w

U
H,b

b
V
h,c
+ (1
b
)V
s
IR.H
b
Identication procedure:
Find the pair

U
H,w
eq
,

U
H,b
eq
that obtains 0 prot in the model without discrimi-
nation.
Set a new
b

>
w

.
If the resulting prot is negative make

U
H,b
smaller until P=0 holding

U
H,w
=

U
H,w
eq
.
If the resulting prot is positive make

U
H,w
higher until P=0 holding

U
H,b
=

U
H,b
eq
.
1
Because they dont bind
37
Appendix I
Toy model of double screening
This appendix oers a toy version of the double screening model developed in chapter
1. The version oered here has the advantage of an analytic solution while maintaining
the main properties of the adult model.
When aiming at an analytic solution we need workable functional forms. We simplify
the production function Y = CS and the utility function U = c
a
c
o
. In addition
we impose uniform distribution functions for the investment costs as well as for the
screening variables: high and low skilled signals and fooling probabilities.
We start working out the value function of a worker receiving a contract w
c
(), w
p
(

I).
I.1 Utility maximization problem
As before agents consume when they are adults c
a
and old c
o
given a ow of payments
(w
a
, w
o
(q)) where q is the probability
1
of attaining w
o
. The maximization problem is:
Max

,c
a
,c
o,h
,c
o,l
U = c
a
_
qc
o,h
+ (1 q)c
o,l
_
(I.1)
subject to
c
o,h
= w
a
+w
o
c
a
(I.2)
c
o,l
= w
a
c
a
(I.3)
The marshallian demands of this worker are: c
a
=
w
a
+qw
o
2
, c
o,h
=
w
a
+(2q)w
o
2
and
c
o,l
=
w
a
qw
o
2
if he is not borrowing constrained; if that were the case c
a
= w
a
, c
o,h
= w
o
.
1
Note we are generalizing, for some workers q is one (i.e. high skilled doing complex tasks), for
others w
o
is 0 (i.e. workers doing simple tasks).
38
APPENDIX I. TOY MODEL OF DOUBLE SCREENING 39
The actual value function of this problem depend, thus, on whether w
a
is greater or
smaller than qw
o
.
V (w
a
, w
o
, q) =
_
(w
a
+qw
o
)
2
4
if w
a
> qw
o
w
a
qw
o
if w
a
< qw
o
(I.4)
I.2 Investment costs and screening variables
All random variables in the model are distributed uniformly for simplicity thus we have:
Investment costs | (a

, b

). Fooling
Fooling probabilities | (a

, b

)
Signals for investors
h
| (a
h
, b
h
)
Signals for non-investors
l
| (a
l
, b
l
)
The cdf of an uniform distribution is F(x) =
xa
ba
and the pdf f(x) = 1/(b a).
I.3 Firms problem
Bibliography
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40