Consider Spence’s job-market signaling model with the
following specifications. There are two types of workers, 1 and 2. The
productivities of the two types, as functions of the level of education E, are
The costs of education for the two types, as functions of
the level of education, are
Each worker’s utility equals his or her income minus the
cost of education. Companies that seek to hire these workers are perfectly
competitive in the labor market.
(a) If types are public information (observable and
verifiable), find expressions for the levels of education, incomes, and utilities
of the two types of workers.
Now suppose each worker’s type is his or her private
(b) Verify that if the contracts of part (a) are
attempted in this situation of information asymmetry, then type 2 does not want
to take up the contract intended for type 1, but type 1 does want to take up
the contract intended for type 2, so “natural” separation cannot prevail.
(c) If we leave the contract for type 1 as in part (a),
what is the range of contracts (education-wage pairs) for type 2 that can achieve
(d) Of the possible separating contracts, which one do
you expect to prevail? Give a verbal but not a formal explanation for your
(e) Who gains or loses from the information asymmetry?