A Sorting cum Learning Model with a Moral Hazard Problem

Abstract

This paper investigates the existence of competitive equilibrium of an information game under the following circumstances: 1) A continuum of test qualities exists where each firm is able to choose one test. Firms offer contracts which are wage/test quality pairs, and they treat contracts of other firms as given. 2) The tests have two kinds of roles. First, as a productivity enhancing device, the tests enhance workers' productivity. Second, as a sorting device, the tests divide workers into those who pass and those who fail. However, tests have a moral hazard problem as a sorting device because workers may choose hidden actions to enhance their test scores. Under the above circumstances, distinctive features of the condition for the nonexistence of the competitive equilibrium are noticed: If a primary purpose of testing workers is to enhance workers' productivity, then the competitive equilibrium of the information game exists. However, if a primary purpose of testing workers is to sort out workers and the tests have a moral hazard problem, the competitive equilibrium does not exist.