Journal Article Wages as Sorting Mechanisms in Competitive Markets with Asymmetric Information: A Theory of Testing Get access J. Luis Guasch, J. Luis Guasch University of California, San Diego Search for other works by this author on: Oxford Academic Google Scholar Andrew Weiss Andrew Weiss Bell Laboratories Search for other works by this author on: Oxford Academic Google Scholar The Review of Economic Studies, Volume 47, Issue 4, July 1980, Pages 653–664, https://doi.org/10.2307/2296934 Published: 01 July 1980 Article history Received: 01 June 1977 Accepted: 01 September 1979 Published: 01 July 1980

Among firms entering a market sequentially, operating under imperfect information and hiring workers with the same observable characteristics, it is shown that in the presence of transaction costs or "lock-in" effects each new firm offers a wage above the one previously offered and obtains higher profits than previous entrants. On average, each new firm gets more able workers than the previous firms, and at any point in time those workers employed by firms are less able than those self-employed. Also, it is shown that a Nash equilibrium entry ordering for firms exits.

In their 1981 article, Joseph Stiglitz and Andrew Weiss analyze adverse selection and incentive effects in the loan market. The models considered are based on two crucial assumptions: borrowers are subject to limited liability; and lenders cannot distinguish borrowers (projects) of different risk. Stiglitz and Weiss show that a bank that raises its interest rate may suffer adverse selection because only risky borrowers will be willing to borrow at the higher rate. Thus lenders may choose not to raise the interest rate to eliminate excess demand, resulting in the possibility of a rationing equilibrium. Stiglitz and Weiss also consider briefly the role of collateral in such credit rationing models. They conclude that lenders may choose not to use collateral requirements as a rationing device. An increase in collateral requirements, like an increase in the interest rate, potentially leads to a decrease in the lender's expected return on loans because of resulting adverse incentive and selection effects. The purpose of this note is to further investigate the role of collateral in these models. Stiglitz and Weiss' discussion in Section III establishes that adverse selection effects can result from increases in collateral when borrowers are risk averse. I will show by returning to a model they discussed earlier in Section I, that the adverse selection effects can also occur when borrowers are risk neutral. Stiglitz and Weiss outline a model to consider the use of collateral as a rationing device (Section III). In that model, all potential borrowers face the same array of risky projects; each potential borrower chooses (at most) one of those projects to undertake. The individuals are, by assumption, risk averse with decreasing absolute risk aversion, and possess different amounts of initial wealth. Thus, choice of project (if any) to undertake and the method of finance-selffinance from initial wealth or loan finance-will differ from one individual to the next. Stiglitz and Weiss show that, among those who undertake risky projects and who choose borrowing as the method of finance, wealthier individuals undertake riskier projects. An increase in collateral has two effects on the market for loans: those individuals who remain in the market will choose to undertake less-risky projects; and those individuals who drop out of the market are less-wealthy, low-risk borrowers. If the second effect is sufficiently strong, then increased collateral requirements will mean decreased expected returns for the lender. Thus, a credit rationing equilibrium may occur, since lenders may not choose to use collateral requirements (or the interest rate) to eliminate excess demand. The adverse selection effect just described does not occur in this model if the individuals are risk neutral. Consequently, the potential for a credit rationing equilibrium is limited to cases where borrowers are risk averse. To see that increases in collateral requirements can also result in adverse selection if borrowers are risk neutral, consider the model Stiglitz and Weiss used to analyze the adverse selection effects of increases in the interest rate (Section I, pp. 395-99). It differs from the Section III model discussed above in three ways. First, borrowers are risk neutral; second, all projects ar loan financed. The analogy to the Section III model is that no individuals have sufficient wealth to self-finance projects.' Third, in the Section

The authors formulate a simultaneous-equation model to explain the wages, output, education, and quit propensities of a sample of production workers. Their principal finding is that individuals that choose more education than they would expect from their observed characteristics have lower than expected quit propensities. This relationship would bias standard estimates of rates of return to education. The authors also find that the output of nonwhites was no lower than that of whites, although their wages on previous jobs were lower, and that workers with high levels of output were more likely to quit than were workers whose output was average. Copyright 1991 by The Review of Economic Studies Limited.