Labour Economics 11 (2004) 599 622

www.elsevier.com/locate/econbase

Labour market signalling and job turnover revisited

Dyuti S. Banerjee, Noel Gaston *
School of Business, Bond University, Gold Coast, Queensland 4229, Australia
Received 14 August 2002; received in revised form 20 June 2003; accepted 9 October 2003
Available online 17 December 2003

Abstract
Turnover by both low and high productivity workers occurs in all jobs. However, the reasons for
turnover by workers of different abilities differ. When the probability that better workers transmit
accurate signals to the labour market increases, we show that incumbent employers are more likely to
adopt a separating wage offer strategy. This reduces the likelihood of turnover by more productive
workers. We also show that turnover depends on a firms willingness to match outside wage offers.
Hence, the personnel and wage policies adopted by employers are important for understanding the
turnover of workers of all productivity types.
D 2003 Elsevier B.V. All rights reserved.
JEL classification: J31; J63; J40
Keywords: Worker turnover; Signalling; Counter-offers; Market Perfect Bayesian Equilibrium

1. Introduction
This paper is concerned with worker turnover. In particular, we investigate why it is that
workers of different abilities or levels of productivity are poached by a firms
competitors. In practice, we observe that workers of both high and low productivity leave
for greener pastures. For instance, Baker et al. (1994a) find that workers who exit were
employed in all types of jobs and at all organisational levels; there is almost no effect of
position within the firms internal labour market on the likelihood of exit. They also note
that the firms administrative procedures as well as the external labour market have an
impact on the exit of workers.
We provide a general model in which workers send signals of their productivity to
the external labour market. When signals are not perfectly informative, we show that
* Corresponding author. Tel.: +61-7-5595-2220; fax: +61-7-5595-1160.
E-mail address: noel_gaston@bond.edu.au (N. Gaston).
0927-5371/$ - see front matter D 2003 Elsevier B.V. All rights reserved.
doi:10.1016/j.labeco.2003.10.001

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there may be some scope for employers to strategically exploit the asymmetry of
information to increase their profits. More specifically, employers choose different
wage strategies depending on how informative the signals are to competitors and how
costly it is to match outside wage offers. For example, if signals are sufficiently
noisy, employers adopt pooling wage strategies which underpay good workers.
By doing so, employers risk turnover by their more productive workers as well as
their less productive workers. However, this risk is attenuated when employers can
match their workers outside wage offers at low cost. Notwithstanding, firms that
successfully poach workers from rivals will sometimes find that they get less than
they bargained for.
The existing theoretical literature on labour market signalling and job turnover does
not address the possibility of turnover by workers of more than one level of
productivity. Existing models essentially fall into three categories. There are models
in which there is no turnover (e.g., Waldman, 1984, 1990), numerous models in which
only the less productive workers turnover (e.g., Kahn and Huberman, 1988; Greenwald,
1986; Bernhardt and Scoones, 1993) and a far smaller number of models in which only
the most productive workers turnover (e.g., Lazear, 1986). As mentioned, taken in
isolation these models do not square with the observation that turnover of both high
productivity and low productivity workers often occurs within the same firm. The model
that we develop has each of these three scenarios embedded as possible outcomes, as
well as the more relevant scenario in which both less and more productive workers
turnover.
In this paper, we show that job turnover may result if a firms wage offer to a worker
depends on the information that firms in the external labour market receive. There is a
considerable body of empirical evidence that indicates that relative wage opportunities are
one of the primary determinants of on-the-job search and the likelihood of turnover by
employees.1 However, it is also the case that . . .those who are well paid in their jobs, as
well as those who are not, exit. . . . they believe that they are likely to do as well in the
external labor market; i.e., that whatever talents made them well paid at this firm are not
very firm-specific (Baker et al., 1994a, p. 913). By extension, the personnel and wage
policies adopted by employers are therefore crucial for understanding the retention or
turnover by workers of all productivity types.
We offer the following story to motivate our model. A firm, which we will refer to as
the initial firm, currently employs a worker. The worker may or may not actively seek
employment at another firm. However, a firm in the external labour market, which we refer
to as the raiding firm, may have an incentive to poach the worker. We assume that a
raiding firm is never able to directly observe the applicants productivity. However, the
raiding firm receives a signal about the worker that may be directly related to productivity.
For example, the signal may take the form of a job referral or, alternatively, a curriculum
vita (or educational qualifications, a list of publications or teaching awards). In the latter
case, academia provides an example of the type of labour market setting that we have in

1
Table 8.1 of Devine and Kiefer (1991, pp. 254 255) provides a comprehensive summary of the key
findings of this literature.

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601

mind.2 However, it should be stressed that our model has far wider application than the
academic labour market alone. For instance, the poaching of senior managers and CEOs
by competitors based on profit or share price signals also fits nicely into the framework
that we describe below.
Obviously, the external labour market may receive noisy signals of worker
productivity. For example, it may be difficult to ascertain from a vita or number of
journal publications whether or not a worker will be good teacher or colleague. In addition,
it may be the case that a worker may strategically choose not to disclose some information
on their vita, because he believes that it may jeopardise his chances of getting outside
wage offers. Consequently, vitae are likely to be less than perfect signals of labour
productivity. We show that it is the noisiness of signals, in conjunction with the initial
wage and counter-offer wage strategy adopted by employers that generates job turnover,
irrespective of a workers type.
The paper is organised as follows. In Section 2, we outline and describe our model setup. In Section 3, we introduce the concept of Market Perfect Bayesian Equilibrium that is
used to determine the wage offers of the initial and the raiding firms. Section 4 contains the
key findings. In Section 5, we provide an extended discussion of the sensitivity of the
findings to the assumptions of our model of job turnover. Section 6 contains the
concluding comments.

2. Model preliminaries
There are three players: the initial firm, F1; a raiding firm, F2; and a worker. A firm can
hire at most one worker. The worker lives for two periods and supplies labour inelastically
in each period. In period 1, F1 learns what the workers productivity, Q, will be in period 2.
In particular, Qa{L, H}, where H (high)>L (low). The production technology is assumed
to be linear and the price of Q is normalised to one. There are no long-term contracts, i.e.,
the worker cannot irrevocably bind himself to any firm.
F2 is a representative firm in a perfectly competitive output market. After receiving a
signal of the workers productivity, F2 may choose to poach him from F1. Our interest
in this paper focuses on the circumstances under which the worker, either a high or low
productivity type, will accept F2s wage offer. The game played between the three players
is specified in extensive form as follows.
Stage 1: F1 observes the workers type, Qa{L, H}, the cost of making a counteroffer, z z 0, and the workers cost of switching employers, c z 0. It then makes an
initial wage offer to the worker, w1( Q)I.
2
Siow (1998) argues that academia has a rather peculiar combination of personnel practices (e.g., tenure and
up-or-out contracts) that are, in large part, explained by informational asymmetries. In addition, publications in
professionally refereed journals signal the ability of professors to transmit the most current knowledge to students.
Siow argues that the peer review and monitoring role provided by journals is rather unique to academia.
Moreover, publications are crucial for generating outside offers that, in turn, drive the current compensation for
academics.

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Stage 2: F2 can observe neither the workers type, nor the workers cost of switching
employers. A priori, F2 believes that Q can be H or L with probabilities p and (1
p),
respectively. F2 receives a signal, sa{0,1}, of the workers productivity and makes
a wage offer, w2(s).
Stage 3: The worker reveals F2s offer to the initial firm only if w2(s)
c>w1( Q)I. F1
receives a message ma{0, s = 0, s = 1}. F1 may or may not choose to make a
counter-offer exceeding w1QI to a worker. The counter-offer, which depends on the
workers type, the initial wage offer and the message that F1 receives, is denoted as
w1(w1( Q)I, m, Q)R. For notational simplicity, we define w1(w1( Q)I, m, Q)R u w1( Q)R.
The payoff to a Q-type worker from remaining with F1 is either w1( Q)I or w1( Q)R. The
payoff from moving to F2 is w2(s)
c. The worker chooses the wage offer yielding the
highest payoff.
If the worker receives an outside wage offer, we assume that it is credible and costlessly
verifiable by F1. That is, if the workers payoff from the outside offer exceeds F1s wage
offer, then the worker reveals the outside offer to F1. Hence, if F2s wage offer to the
worker is better than F1s original wage offer, then F1 learns the signal received by F2.
Note that the initial employer has the option to make counter-offers to workers who
receive wage offers from the external labour market. We assume that F1s counter-offer
cannot be lower than its initial offer to the worker.3 If a worker does not approach F1 for a
counter-offer, then F1s initial wage offer must be at least as good as the outside wage
offer, net of the switching cost.
The cost of making counter-offers, z, affects the wage strategy of the initial
employer. The variable z captures the cost of renegotiating contracts with employees
who receive outside offers or alternatively, the cost associated with a firm changing its
wage structure. Baker et al. (1994a,b) provide empirical findings consistent with the
firm and organisational environment that we have in mind. For example, they find that
firms have rigid hierarchical structures and wage policies that tend to be simple, easyto-understand and extremely stable across time.4 In addition, there is what they term a
fast track exit effect in which the fastest promotees (i.e., most productive workers)
exit more frequently. Perhaps some very high ability workers are not optimally
employed at the firm, or the firm is not paying wages equal to expected marginal
products for these employees. The latter interpretation is consistent with administrative
constraints on pay levels (Baker et al., 1994a, p. 903). In effect, the firm is
administratively constrained by being unable to give the best performers large pay
increases. These wage rules and administrative constraints create a wedge between an
employees pay and what pay would be in an external spot market (Baker et al.,
1994a, p. 913).

3
We exclude the possibility, suggested by Lazear (1986), that the absence of a counter-offer gives the firm a
pretext to reduce a workers wage.
4
This suggests that firms choose their wage strategies so that they are ex ante optimal. The strategies are
codified into rules and relatively fixed wage and salary structures. Naturally, there may be ex post regret, if the
better workers depart.

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If signals are perfectly informative to a raiding firm, we show below that, for all but
prohibitive switching costs, F1 would employ a separating wage strategy, i.e., it offers
w1(H)I = H
c and w1(L)I = L
c to high productivity and low productivity workers,
respectively. F1 would never pay less than these wages because counter-offers are
costly and the retention of workers is profitable. If a workers signal to the external
labour market truly reflected productivity, then, in a similar fashion to Waldmans
(1984) job assignment model, any worker would always remain with their initial
employer.
In Waldman (1984), the workers wage and the job assignment pair are both publicly
observable. The job assignment is related to the output of the worker. Hence, even though
the productivity of the worker is private information to the initial firm, the external
market gets a signal about worker productivity from the job assignment. Since job
assignments are publicly observable, the initial firm cannot conceal information about the
productivity of the worker. However, inefficient outcomes may result due to the initial
firms private information about the workers productivity. Specifically, inefficiency is
manifested by the employers strategic choice of a threshold level for assigning workers
to the higher-level jobs.
In real life, signals of worker productivity are unlikely to be perfectly informative. For
example, whether by design or not, it seems reasonable to expect that signals provide noisy
information about worker productivity. The information structure we consider is as
follows. For simplicity, we assume that the signal, s, takes two values, 0 or 1. If the
workers type is H then the signal takes the values 1 and 0, with probabilities q and (1
q),
respectively. If the workers type is L, then the signal takes the values 1 and 0 with
probabilities r and (1
r), respectively. That is,
Probs 1 j Q H q
Probs 0 j Q H 1
q
Probs 1 j Q L r
Probs 0 j Q L 1
r:

Without loss of generality, we assume that q>r. This means that the probability of
receiving s = 1 is higher if the workers type is H and the probability of receiving s = 0 is
higher if the workers type is L. Accordingly, we refer to s = 1 as the good signal and to
s = 0 as the bad signal.5

5
If r>q is assumed, then (1
q)>(1
r), i.e., the probability of getting s = 0 is higher if the workers type is
H and the probability of getting s = 1 is higher if the workers type is L. So, in this case, s = 0 is the good signal
and s = 1 is the bad signal. Hence, irrespective of whether q>r or r>q is assumed, it is always the case that the
probability of receiving a good signal is higher if the workers type is H.

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After receiving a signal, F2 updates its belief about the expected productivity of the
worker and then decides on its wage offer. We let EQ(s) denote F2s expectation of the
workers productivity after it receives the signal, s, i.e.,
EQs ProbH j sH ProbL j sL:

The expected productivity of the worker as perceived by the raiding firm,

corresponding to each of the signals, is given by Bayes rule, i.e.,
ProbQ X j s i rQ X j s i

ProbQ X ; s i
;
Probs i

where Xa{L, H} and ia{0, 1} The draw of the signal and the draw of productivity are
independent. The conditional probabilities are given by
rQ H j s 1

pq
d
pq 1
pr

rQ L j s 1

1
pr
1
d
pq 1
pr

rQ H j s 0

p1
q
c
p1
q 1
p1
r

rQ L j s 0

1
p1
r
1
c:
p1
q 1
p1
r

Note that r( Qjs) denotes F2s updated belief about the workers type after it has
received the signal. Using Eqs. (4) (7), the expected productivities associated with the
different signals are
EQs 1 dH 1
dL

EQs 0 cH 1
cL:

Since c < p < d we have EQ(s = 1)>EQ(s = 0). Thus, expected output of a worker who
provides a good signal unambiguously exceeds that for a worker sending a bad signal.

3. Equilibrium of the signalling game

We now discuss the payoffs to F1 and F2 and define the equilibrium solution concept.
Before discussing the wage offer strategies for the two firms, we impose some restrictions
and introduce some further notation. Both firms wage offers are non-negative and less
than H. That is, the offer strategy space for each firm is [0, H]. We divide [0, H] into two

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sub-intervals, W l=[0, L] and W h=(L, H]. We let wil (or wih) denote the wage offer of firm
Fi, i = 1, 2, which is an element of W l (or W h).
The initial firm never makes a wage offer that exceeds the productivity of the worker;
otherwise, it would make a negative profit. Hence, F1 offers a wage w1haW h, if at all, only
to an H-type worker. Therefore, F1s strategy could be to offer w1h to an H-type worker and
w1l to an L-type worker. Alternatively, it could offer w1l to both types of workers. The initial
firms wage offer strategy is a contingent plan of action, i.e., an initial wage and a wage
counter-offer pair, w1( Q)=(w1( Q)I, w1( Q)R), Qa{L, H}.
We now analyse the equilibrium wage offers of the two firms. Let p1 and p2 denote the
payoffs to F1 and F2. Since the external market is perfectly competitive, all firms in the
external market receive the same signal and F2s wage offer equals the expected output of
the worker. The initial firms equilibrium strategy is to maximise its expected profit, given
the external markets strategy. We call the equilibrium concept the Market Perfect
Bayesian Equilibrium (MPBE), which is formally defined as follows.
Definition 1. The MPBE of the game consists of F2s updated belief, s( Qjs) formed by
Eqs. (4) (7), F2s equilibrium wage offer, w2(s)*, and F1s equilibrium wage offer
strategy, w1( Q)*=(w1( Q)I*, w1( Q)R*), where w1( Q)I is the initial wage offer and w1( Q)R
is the wage counter-offer, satisfying the following conditions for Qa{L, H}.
r( Qjs) z 0.
r(H js) + r(Ljs) = 1, for sa{0, 1}.
For
P each signal, s, F2s equilibrium offer, w2(s)*, is the solution to
QafL;Hg rQ j sp2 Q; s; w2 0 . In particular, w2(s)*= EQ(s), where EQ(s)
is the expected productivity of the worker corresponding to signal s.
C4a. A counter-offer is profitable for F1 if w1( Q)I < w2(s)*
c = w1( Q)R and p1(w1
( Q)R; Q, z) = Q
w1( Q)R + c
z>0. The equilibrium wage offer strategy is w1
( Q)*=(w1( Q)I*,w1( Q)R*, where w1( Q)R*arg max p1(w1( Q)R; Q, z) and w1( Q)I*=
arg max Ep1(w1( Q); Q, z) = xp1(w1( Q)I; Q)+(1
x)p1(w1( Q)R*; Q, z), where
p1(w1( Q)I; Q) =Q
w1( Q)I + c and x is the probability of retaining the worker at
the initial wage offer.
C4b. If a counter-offer is not profitable, then F1s equilibrium wage offer strategy is
w1( Q)*= w1( Q)I*= arg max Ep1(w1( Q); Q) = xp1(w1( Q)I; Q).

C1.
C2.
C3.

The workers actual productivity and the cost of moving are private information to the
initial firm and the worker. This asymmetry of information prevents the movement of a
worker, i.e., whether he remains or stays with his initial employer, from providing any
information about his actual productivity. Moreover, the competitive output market
ensures that any wage offer made by F2 satisfies the zero profit constraint. It is the
asymmetric information about the workers actual productivity and the competitiveness of
the outside market which ensures that w2(s)* = EQ(s).6
6
Waldman (1984) introduced the concept of Restricted Market Nash Equilibrium (RMNE), in which the
original employers wage offer is chosen to maximise its profit and the outside markets strategy is consistent with
the zero expected profit constraint. While the RMNE has equilibrium strategies, unlike the MPBE, there is no
updating of beliefs and therefore no equilibrium beliefs.

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If the external labour market can perfectly observe a workers type, as revealed by his
movement, then as in Waldman (1990), only the low productivity workers would ever
move to other firms. Accordingly, the labour market would completely breakdown as in
the market for lemons (see Greenwald, 1986). In our model, there is no job assignment
related to the output of the worker that can prevent the initial firm from lying. We use the
MPBE concept in order to capture the idea of credible threats and promises that form the
foundation of the concept of Perfect Bayesian Nash Equilibrium.7

4. The equilibrium analysis

In this section, for given costs of switching to a new employer, worker turnover is
shown to be driven by two important factors: the noisiness of the signals that workers
convey to the external labour market and the willingness of incumbent employers to match
outside wage offers. We first show that asymmetric information about a workers
productivity is a necessary, but not sufficient, condition for worker turnover. Specifically,
when labour market signals are perfectly informative, we show that employers will
implement a separating wage strategy. This yields zero worker turnover, independent of
the cost of making counter-offers and the cost of worker mobility.
We then investigate the second of the two factors by considering the case in which
counter-offers are made by F1. When the costs of worker mobility are not prohibitive, we
show that there may be job turnover, albeit only by low productivity workers. Finally, we
consider the case in which making counter-offers to workers is unprofitable. In this case,
there can be job turnover by workers of both productivity types. Thus, it is only when both
assumptions, low costs of making counter-offers and imperfectly informative labour
market signals, are simultaneously satisfied that we observe turnover by both high and
low productivity workers in equilibrium.
To determine the equilibrium wage offers of the initial firm and raiding firm, we specify
three ranges of the switching cost.8
Definition 2.
a. Low switching costs: ca[0, EQ(s = 0));
b. Moderate switching costs: ca[EQ(s = 0), EQ(s = 1));
c. Prohibitive switching costs: c z EQ(s = 1).
To highlight the importance of noisy information for job turnover, we first consider the
simplest case in which there are perfectly informative signals. When q = 1 and r = 0, a good
signal is always received if the worker is an H-type and a bad signal is always received if

7
The MPBE concept differs from a Perfect Bayesian Equilibrium in that only one player maximises his
payoff, while the firms in the external labour market choose their wage offer to satisfy the zero expected profit
constraint.
8
Clearly, it is trivially the case that workers with prohibitive switching costs will never turnover. However,
we present the analysis for this cost range for completeness.

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607

the worker is an L-type. The equilibrium is characterised in Proposition 1. (All proofs are
relegated to Appendix A).
Proposition 1. Perfectly informative signals. Suppose that the signals give perfect
information about the workers type, i.e., r(Q = Hjs = 1) = 1, r(Q = Ljs = 1) = 0,
r(Q = Hjs = 0) = 0 and r(Q = Ljs = 0) = 1, then the MPBE is given by w2(s = 1)*= EQ(s =
1) = H and w2(s = 0)*= EQ(s = 0) = L and
(a) Low switching costs: ca[0, L)

w1 QI Q
c; QafL; Hg:
There is no turnover by any type of worker.
(b) Moderate switching costs: ca[L, H)

w1 HI ; w1 LI H
c; 0:
There is no turnover by any type of worker.
(c) Prohibitive switching costs: c z H

w1 QI 0:
There is no turnover by any type of worker.
Unless switching costs are prohibitive, the initial employer adopts a separating wage
offer strategy. The worker, irrespective of type, remains with the initial firm for all c.
Clearly, making a counter-offer is unnecessary. (Obviously, w2(s)
c V w1( Q)I). As the
moving cost rises, F1s wage offer falls. The switching cost acts like a hold-up cost, of
course. Therefore, the initial firm can retain the worker by offering lower wages. In the
limit, with prohibitive moving costs, F1s wage offer is zero.9
The results for the perfectly informative signalling case are qualitatively similar to
thinking of the wage offers made by F1 as a promotion or a better job assignment.
Therefore, the sub-optimal task assignment result in Waldman (1984, 1990) pertains.
However, the absence of turnover in the present case is efficient, since all firms equally
value workers and turnover costs are a deadweight loss. Of course, the complete absence
of turnover is counterfactual.
In the next two Propositions, we show that imperfectly informative signals, low costs of
mobility and high costs of making counter-offers are sufficient conditions for job turnover.
Note that F1 may or may not make a counter-offer. Recall that F1 makes a counter-offer, if
and only if w2(s)
c>w1( Q)I and p1(w1( Q)RjQ; z) = Q
w1( Q)R
z>0 both apply.
Otherwise, if either w2(s)
c V w1( Q)I or p1(w1( Q)RjQ; z) < 0 hold, then F1 leaves the
initial wage offer unchanged. In other words, if the workers outside wage offer exceeds
9
Ransom (1993) argues that the negative wage premium for additional years of seniority in academia is
largely explained by moving costs. Ceteris paribus, higher moving costs contribute to both increased worker
immobility and to lower wages for the non-movers. Farber (1999, p. 2468) notes that workers may change type
overtime by becoming less mobile on average. This could reflect maturation of young workers as they acquire
families and settle into their careers.

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F1s initial wage offer, an initial employer will only make a counter-offer if it is profitable
to match the outside offer. Proposition 2 contains the results for the case in which a
counter-offer strategy is optimal. (The proof is in Appendix A).
Proposition 2. Imperfectly informative signals and counter-offers. F2s equilibrium
strategy is given by w2(s = 1)*= EQ(s = 1) and w2(s = 0)*= EQ(s = 0). If w2(s)
c>w1(Q)I
and z < Q + c
w2(s) both apply, then F1s equilibrium wage offer strategy is

i. w1 Q w1 QI EQs 0
c; w1 QR EQs 1
c; if EQs 0

c > 0 and 1
nEQs
1
EQs 0
nz > 0;

ii . w1 Q w1 QI 0; w1 QR EQs 1
c;
if EQs 1
c > 0zEQ
s 0
c and 1
nEQs 1
c
nz > 0;
where Qa{L,H} and na{r,q}. Specifically, w1(L)* and w1(H)* are as follows.
Case 1: Q = L and s = 1. w1 L* 0; EQs 1
c; where ca[d(H
L), EQ(s = 1))
and (1
r)[EQ(s = 1)
c]
rz>0
Case 2: Q = H and s = 1.
a. w1 H* EQs 0
c; EQs 1
c; where ca[0, EQ(s = 0)) and
(1
q)[EQ(s = 1)
EQ(s = 0)]
qz>0.
b. w1 H* 0; EQs 1
c; where ca[EQ(s = 0), EQ(s = 1)) and
(1
q)[EQ(s = 1)
c]
qz>0.
The most obvious feature of Proposition 2 is that the initial employer only needs to
make a counter-offer if the worker sends a good signal to the external market.
Consequently, if making counter-offers is sufficiently inexpensive, it may be profitable
to offer workers a low wage initially and then to simply match an outside offer if
workers happen to send a good signal. (However, it is interesting to note that paying an
initial wage equal to zero is not always the optimal strategy because of the cost of
making counter-offers). The implications for turnover probabilities are easily
illustrated.
Corollary 1. Suppose that the worker receives an outside wage offer w2(s)
c>w1(Q)I
and that z < Q + c
w2(s) both apply. Then, in an MPBE, the turnover probabilities, t i,
i = l, h, for each worker type are given by
H-type worker:
t h 0; for all cz0:
L-type worker:
If c < c0 ; then t l 1; if cac0 ; c1 ; then t l r; otherwise t l 0;
where c0 = c(H
L) and c1 = d(H
L).
The initial firm has the incentive to retain workers because by doing so it makes the
non-negative profit, c. In this sense, c is qualitatively equivalent to a match-specific rent.

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Note that an H-type worker is always retained. For an L-type worker who has sent a good
signal and received a wage offer of EQ(s = 1), the wage needed to retain this worker may
be too high for low values of c. Hence, low productivity workers may turnover.
Finally, we turn to the case in which no counter-offers are possible. Irrespective of the
cost range, from the definition of MPBE, we know that F2 will always make one of two
wage offers to a worker, viz., EQ(s = 0) or EQ(s = 1). F1 knows the workers productivity
and chooses its wage offer to maximise profits. If it adopts a pooling wage strategy, F1
risks losing its high productivity workers; if it adopts a separating wage strategy, F1 retains
its high productivity workers, but has higher wage costs. Proposition 3 contains the results.
(The proof is provided in Appendix A).
Proposition 3. Imperfectly informative signals and no counter-offers
Suppose that F2 receives a signal, s, of the workers productivity. If either of the
following two conditions hold:
i. w2(s)
c V w1(Q)I, for any z, or
ii. w2(s)
c>w1(Q)I and z>Q + c
w2(s),then a counter-offer will not be made. F2s wage
offers are given by w2(s = 1)*= EQ(s = 1) and w2(s = 0)*= EQ(s = 0). The equilibrium
wage offer strategy for F1, w1(Q)*= w1(Q)I*, Qa{L,H}, is given by
(a) . Low switching costs: ca[0,EQ(s = 0))
8
EQs 0
c; wl1
>
>
>
>
<
w1 H ; w1 L EQs 1
c; wl1
>
>
>
>
:
EQs 1
c; EQs 0
c

if ca0; cA
if cacA ; c0
if cac0 ; EQs 0;

where c0 = c(H
L) and cA d
c
q1
c

H
L;
q
(b) . Moderate switching costs: ca[EQ(s = 0), EQ(s = 1))
8
0; 0
>
>
>
>
<
w1 H ; w1 L EQs 1
c; 0
>
>
>
>
:
EQs 1
c; EQs 1
c

if caEQs 0; cB
if cacB ; cC
if cacC ; EQs 1;

where cB=(d
q)H+(1
d)L and cC = d(H
L)+(1
r)L;

(c) . Prohibitive switching costs: c z EQ(s = 1)
w1 H ; w1 L 0; 0:
Within each cost range, there is a critical cost level that indicates when it is more
profitable for F1 to pay its H-type worker a wage the same as, or different from, the
wage offered to an L-type worker. To illustrate, consider the critical cost level cA within
the low cost range. For moving costs less than cA, F1 pays the H-type worker

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EQ(s = 0)
c and risks losing the worker with probability q. For moving costs greater
than cA, it is more profitable for F1 to pay the H-type worker EQ(s = 0)
c and retain
him with certainty.10
The characterisation of the turnover probabilities for the various switching cost ranges
is summarised in Corollary 2. Before doing so, in Lemma 1, we describe some
properties of the critical switching cost levels that determine which wage strategy the
initial employer finds most profitable to employ.
Lemma 1. For q z r>0,
(i) If cA < EQ(s = 0)ZcB < EQ(s = 0);
(ii) If cA z EQ(s = 0)ZcB z EQ(s = 0);
(iii) EQ(s = 1) z cC>EQ(s = 0) and cC z cB.
Corollary 2. In an MPBE, for each worker type, the turnover probabilities, t i, i = l, h, are
given by
H-type worker:
(i) If cA = cB = EQ(s = 0), then t h = q for ca[0, EQ (s = 0)), otherwise t h = 0;
(ii) If cA < EQ(s = 0), then t h = q for c a[0,cA), otherwise, t h = 0;
(iii) If cB>EQ(s = 0), then t h = q for ca[0, cB), otherwise t h = 0.
L-type worker:
If c < c0 ; then t l 1; if cac0 ; cC ; then t l r; otherwise; t l 0:
The intuition behind our results is readily conveyed by graphs of the profit
function for the initial employer for the various ranges of the workers switching
cost. Figs. 1 and 2 depict the initial firms profit functions for the L-type and H-type
workers, which we denote by p1l and p1h. The graphs also summarise the relevant
information about the initial firms adoption of a separating or pooling wage strategy
as well as what the turnover probabilities for the various cost ranges and wage
strategies are.
First, consider Fig. 1 and the L-type worker. For switching costs up to c0, the raiders
wage offer, net of moving costs, exceeds L
c and the initial firm never retains an L-type
worker for any signal that F2 receives (i.e., t l = 1). The initial firms profits are zero. For
costs greater than c0 in the low cost range, F1s offer to an L-type worker is less than L.
The maximum offer that an L-type worker can get from the raiding firm is EQ(s = 1).
Since, F1s equilibrium offer to an L-type worker is EQ(s = 0)
c, an L-type worker is
10
In general, our model implies that turnover declines with mobility costs. Farber (1999) provides a model in
which workers are differentiated by their turnover probabilities. He argues that heterogeneity in mobility rates can
largely account for the central facts about inter-firm worker mobility in modern labour markets (e.g., the
probability of a job ending declining with tenure) without resort to the existence of specific capital.

D.S. Banerjee, N. Gaston / Labour Economics 11 (2004) 599622

611

Fig. 1. Profit function: L-type worker.

retained by F1 only if the external market receives a bad signal, which occurs with
probability (1
r), hence, t l = r. Beyond critical cost level cC, the L-type is always
retained.
The three panels of Fig. 2 display the profit functions of the initial firm corresponding
to the three cases described in Lemma 1.11 In the range [0, cA) in Case 2, F1s maximum
offer to an H-type worker is only EQ(s = 0)
c. For the initial employer, the expected
profits from exposing an H-type worker to some risk of turnover is higher than that that
would be obtained by paying the higher separating wage, EQ(s = 1)
c, which would
retain the worker with certainty. A raiding firm cannot offer less than EQ(s = 1), because
firms in the external labour market make wage offers consistent with zero expected
profits. Consequently, in the lowest cost range, the initial firm can retain the H-type
worker only if the external market receives s = 0. Hence, t h = q. In the range [cA,
EQ(s = 1)), F1 finds it more profitable to pay the higher wage to the H-type worker
and to retain the worker with certainty.
From Case 3 of Fig. 2, in the moderate cost range note that F1s wage offers can be
either 0 or EQ(s = 1)
c. (In this cost range, note that EQ(s = 0)
c is less than 0). Hence,
if F2 receives a bad signal, the worker remains with F1 irrespective of their type, because
by switching the payoff would be negative. For the different sub-ranges within the
moderate cost range, the cost level cB represents the critical cost at which F1s expected

11

In the perfect signalling case, we have cA = cB = EQ(s = 0) = 0, so that the profit function for the H-type
worker consists of the last two segments of the profit function in Case 1 of Fig. 2. For the L-type worker,
cC = EQ(s = 1) = H, so that the profit function consists of the last two segments of the profit function in Fig. 1.

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D.S. Banerjee, N. Gaston / Labour Economics 11 (2004) 599622

profit from offering higher wages to an H-type worker, and retaining them with certainty,
is equal to the expected profit from making a zero wage offer. Wage offers of zero will
lead to turnover of H-type workers if the worker transmits a good signal, which occurs
with probability q.

Fig. 2. Profit Function: H-type worker.

D.S. Banerjee, N. Gaston / Labour Economics 11 (2004) 599622

613

Fig. 2 (continued).

Finally, from Case 3 of Fig. 2, note that initial firms are more likely to expose their
good workers to some risk of turnover as q falls.12 Intuitively, as q falls, the risk of losing
a good worker to poaching falls. Consequently, employers take a calculated risk by
underpaying their workers and adopting a pooling wage strategy.
Overall, the initial employer takes into consideration the signals that the external
market is likely to receive and the associated risk of worker turnover. Since the initial
firm can make non-negative profits by retaining a worker, irrespective of type, it has an
incentive to avoid turnover. However, an L-type workers maximum wage is L and for
an H-type worker the wage range constitutes the entire range of productivity. Our
analysis of the noisy signalling scenario shows that, except for prohibitive switching
costs, the retention of an H-type worker not only depends on the wage offer of the initial
firm, but also on the offer by the outside firm. In turn, this depends on the signal
received by the market. This occurs because, for some range of switching costs, it may
be profitable for an employer to underpay good workers and expose them to some
risk of being poached. This incentive does not arise for low productivity workers. In
general, retention of L-type workers depends purely on the signal received by the
market. Accordingly, L-type workers are always more likely to turnover than H-type
workers.
12
Note that cB = EQ(s = 1
qH ), so that cB ! EQ(s = 1) as q ! 0. Hence, while the actual turnover
probability is lower, the range of costs over which the initial firm will expose an H-type worker to some risk of
being poached increases. Further, as cB increases, the range of costs for which the initial firm adopts a pooling
strategy increases.

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For the case in which counter-offers are possible, the initial employer has an
incentive to underpay initially and then to simply match an outside offer should it
be the case that the worker sends a good signal. Comparison of Corollaries 1 and 2
reveals that, when counter-offers are profitable, that an H-type worker never leaves and
that the cost range for which an L-type worker may turnover is smaller in the case when
counter-offers are possible (since c1 < cC). To rationalise observed turnover by H-type
workers in equilibrium, not only must it be the case that signals are noisy but, in
addition, the cost of making counter-offers must be significant.

5. Discussion
In this paper, the results about worker turnover rely on the assumption that the
external labour market receives noisy signals about worker productivity. In addition, it
is necessary that firms in the external market receive no other information or signals
that would help them to determine a workers actual productivity. To ensure that the
external market does not get any other signal about worker productivity that may be
sufficiently informative to make the original noisy signals of worker type irrelevant, we
assumed that switching costs are private information to the worker and the incumbent
employer. In effect, asymmetric information about worker switching costs prevents the
external market from deriving information about the initial firms wage offers to
workers of different types. To understand the sensitivity of our findings to the
assumptions of our model, in this section, we discuss some alternative information
structures. In particular, we show that, if switching costs were public knowledge, or
equivalently if wages were publicly observable, that there would be no turnover in
equilibrium.
Let us suppose that the initial employers wage offer is publicly observable. That is,
wages act as a signal. However, wages are an imprecise signal of productivity. A
priori, F2 knows that the worker is an H- or L-type with probabilities p and (1
p).
After F2 observes F1s wage offer, it updates its belief about the productivity of the
worker and then makes its own wage offer.
First, consider the separating equilibrium, i.e., F1 uses the strategy (w1(H),w1(L))=
(w1h,w1l). F2 knows that a worker offered w1h(w1l) by F1 is of H- (L-) productivity, i.e., r( Q =
Hjs = w lh) = 1 and r( Q = Ljs = w hl ) = 1. Consequently, F2 will offer H (or L) to an H- (or L-)
productivity worker. If F1 is using the separating strategy, it knows ex ante that F2 will make
these offers. Therefore, its strategy will be to offer w1(H) = H
c and w1(L) = L
c. Clearly,
a worker of either type would elect to stay with F1.
However, F1 has an incentive to deviate. Suppose that F1 offers w1l to an H-type worker.
If the raiding firm believes that the workers type is low it therefore offers a wage L.
Consequently, the H-type worker would stay with the initial employer. Thus, the separating
equilibrium does not exist. However, pooling equilibria do exist. That is, after observing
w1l, F2s updated beliefs are r( Q = Hjs = w ll) = p and r( Q = Ljs = w ll)=(1
p). Accordingly,
being unable to determine a workers type, F2 offers the workers expected output. The
results for the wage signalling case are summarised in Proposition 4. (Proofs are in
Appendix A).

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615

Proposition 4. Publicly observable wages

If F2 has perfect information about the wage offer of F1, and this is common knowledge,
then there exists a continuum of pooling equilibria for c z p(H
L) and for all z>0. The
equilibrium wage offer strategies are given by
(i) w2(s = w1l)*= EQ(s) = L + p(H
L) and
(ii) w1(Q)*= EQ(s)
c, if ca[p(H
L), L + p(H
L)],
where Qa{L,H}. There is no turnover by any type of worker.
The analysis implies that the existence of a pooling equilibrium in pure strategies, as
long as c z p(H
L). The maximum wage offer that guarantees the existence of a pooling
equilibrium cannot exceed L. Furthermore, since F2 perfectly observes the wage offer
made by F1, it is not possible for F1 to offer different wages to different types of workers
even in the range [0, L] because, once again, F2 would be able to infer a workers actual
productivity. The relative underpayment of H-type workers occurs because the initial
firm is able to exploit its private information.
In this paper, we have focussed on the cases in which F2 cannot perfectly observe the
wage offer of F1 but receives imperfectly informative signals of worker productivity.
Imperfect information about worker switching costs is therefore necessary. (Recall that
these costs represent the initial employers rents in equilibrium). F1 knows that the
raiding firm has received noisy information, but is never sure about the signal it has
received unless the worker returns to the initial employer for a counter-offer. The case in
which switching costs are public information is equivalent to the case in which the
raiding firm receives a signal about a workers type and perfectly observes F1s wage
offer. In turn, both cases are associated with zero worker turnover, as described in
Proposition 4.
The point, of course, is that any meaningful equilibrium solution requires consistency
in the belief structure of F1 and F2 regarding each others wage offer strategies. If F1
offers anything greater than L, F2 knows with certainty that the worker is an H-type and
so offers H. If F2 believes that F1 uses a separating wage strategy, then F2 will always
offer L if it observes w1(L) = L. However, F1 may deviate from its separating strategy and
offer L to an H-type worker if it believes that F2 always offers L if it observes L. But,
then it is also possible that F2 also deviates from its strategy of offering L if it observes L
by offering EQ(s). In this case, beliefs are inconsistent. That is, any other types of
information or signals from which the raiding firm may ascertain the workers type
disturbs the equilibrium concept outlined in the definition of MPBE.13

13
Changing the staging of the game is an alternative way in which our turnover results may be replicated. For
example, if the initial employer and firms in the external market simultaneously offer wages, the possibility of
inconsistent beliefs in equilibrium is avoided. In this case, if there is asymmetric information about a workers
productivity and a sufficiently high cost of making counter-offers, then both types of workers may turnover in
equilibrium. The reason why good workers may turnover is that the initial employer may gamble on H-type workers
sending bad signals and paying a pooling wage. We are grateful to an anonymous referee for this observation.

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D.S. Banerjee, N. Gaston / Labour Economics 11 (2004) 599622

It is also important to note that private information about the workers switching cost
together with the noisy signals is sufficient to guarantee the existence of equilibrium.
Informational asymmetry about the cost of making counter-offers is not necessary for the
equilibrium analysis. The fact that the switching cost is private information to F1 and the
worker makes it impossible for the raiding firm to gauge whether a counter-offer will be
made or not.14

6. Concluding comments
Most previous theoretical research has shown that it is the least productive workers
who are the more likely to change jobs. In contrast, empirical research has shown that
the most productive workers are equally, if not more, likely to change jobs. In this paper,
we have shown that turnover by both high productivity and low productivity workers is
possible when information about the productivity of workers is noisy and making
counter-offers is costly. The informational asymmetry prevents the firms competitors
from knowing the workers exact productivity type. In other words, the movement of the
worker, i.e., whether he remains with or leaves his current employer, does not convey
any information about actual productivity. Consequently, there may be turnover of both
types of workers.
In the case of low productivity workers, labour turnover depends upon the signal
received by the raiding firm. In contrast, the likelihood of turnover by more productive
workers depends upon the initial employers wage offer, the possibility of making a
counter-offer and the signal received by the raiding firm. Specifically, we showed that in
the case in which making counter-offers is too costly, it may be profitable for an
employer to adopt a pooling wage strategy and expose their better workers to some risk
of being poached by outside firms than to adopt a separating wage strategy that would
retain all workers with certainty.
While we find that less productive workers are more likely to turnover, as
discussed by Greenwald (1986), the labour market does not completely breakdown
as in the market for lemons. In our model, inefficiencies arise because of
asymmetric information and switching costs. We have shown that there are efficient
outcomes where the least productive workers get a low wage and the most productive
workers get a high wage. However, we also showed that there are situations in which
inefficiencies may arise, in a similar fashion to Waldman (1984, 1990). Some of the
workers who would have been more efficiently employed in higher ranking or more
highly paid positions are not promoted, because the job assignment signals worker

14
To illustrate, consider the switching cost range, ca[0, EQ(s = 0)), which is private information to F1 and
the worker. F2 always offers EQ(s). In this cost range, F1 will never make any counter-offers to an L-type worker,
as shown in Proposition 2. Since F2 does not know the cost range, it therefore does not know whether a counteroffer will be made or not. Therefore, asymmetric information about the cost of making counter-offers is not a
necessary condition in our analysis.

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617

productivity to competitors. In the case of up-or-out contracts, the outcome is

efficient provided that the criteria for promotion are credible and enforceable. In
the case of academia, for example, promotion and salary decisions signal worker
productivity to poaching firms, but can often be subjective and highly discretionary.
In turn, this noisiness of signals implies that efficient outcomes may be not always
be achieved.

Acknowledgements
The paper has benefitted from the suggestions of the editor, an anonymous referee
and the participants in the seminars at which it was delivered. In particular, the
authors would like to thank Art Goldsmith, Hideshi Itoh, Jeff Kline, Hodaka Morita,
Dan Sasaki and Mike Waldman. Naturally, the usual disclaimers apply.

Appendix A
Proof of Proposition 1. First, note that the signals give perfect information about the
workers type, i.e., EQ(s = 0) = L and EQ(s = 1) = H. Therefore, it follows that F2 offers
w2(s = 0)*= L and w2(s = 1)*= H.
(a) Low switching costs: ca[0, L). Next, note that 0 < EQ(s = 0)
c V L and
EQ(s = 1)
c>0. It follows that F1s equilibrium offers are w1(L)I*= L
c and
w1(H)I*= H
c. The worker, irrespective of type, remains with F1.
(b) Moderate switching costs: ca[L, H). F1 offers w1(L)I*= 0 and w1(H)I*= H
c. Once
again, the worker, irrespective of type, remains with F1.
(c) Prohibitive switching costs: c z H. F1s offer is w1(H)I*= w1(L)I*= 0. The workers
payoff is non-positive if he switches to F2, irrespective of his type. Hence, the worker
remains with F1.
5
Proof of Proposition 2. Fig. 3 gives a diagrammatic representation of the game with
counter-offers. The game begins with F1 making an initial wage offer to a Q-type worker,
w1(Q)Ia{0,EQ(s = 0)
c, EQ(s = 1)
c}. F2 receives a signal s. Prob(s = 1jQ) = n and
Prob (s = 0jQ) = 1
n, n = r, q corresponding to Q = L, H. F2 updates its belief according to
Eqs. (4) (7), determines the expected productivity of the worker, EQ(s) and makes a wage
offer, w2(s)*= EQ(s).
First, assume that EQ(s)
c>0. The worker may or may not approach F1 for a counteroffer. The expressions at the end of each branch of the game tree are the realised profits for
F1.
(i) w1(Q)I = 0. In this case, the worker approaches F1 and discloses the outside offer,
which is EQ(s = 1) with probability n and EQ(s = 0) with probability 1
n. If F1

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D.S. Banerjee, N. Gaston / Labour Economics 11 (2004) 599622

Q

EQ ( s = 1) + c

z
Q

EQ ( s = 0) + c

EQ ( s = 0) + c

s=0 with
prob. 1-n

s=1 with
prob. n

s=0 with
prob. 1-n

s=1 with
prob. n

!
EQ ( s = 0)

EQ ( s = 1) + c

EQ ( s = 1) + c

EQ ( s = 1)

w1 (Q )

Fig. 3.

matches the outside offer, then its profit is Q
EQ(s = 1) + c
z with

probability n or Q
EQ(s = 0) + c
z with probability 1
n. So F1s expected
profit from offering w1( Q)I = 0 is
Ep1 Q; w1 QI 0 np1 Q; w1 QI 0; w1 QR EQs 1
c
1
np1 Q; w1 QI 0; w1 QR EQs 0
c
Q
nEQs 1
1
nEQs 0 c
z: A1
(ii) w1( Q)I = EQ(s = 0)
c. In this case, the worker approaches and discloses the outside
offer only if it is EQ(s = 1), which occurs with probability n. If F1 matches the outside
offer (net of the mobility cost), then the expected profit of F1 corresponding to
w1( Q)I = EQ(s = 0)
c is
Ep1 Q; w1 QI EQs 0
c np1 Q; w1 QI EQs 0; w1 QR
EQs 1
c 1
np1 Q; w1 QI w1 QR
EQs 0
c Q
nEQs 1
1
nEQs 0
c
nz:

A2

(iii) w1( Q)I = EQ(s = 1)
c. In this case, no counter-offers are necessary. The expected
profit of F1 is
Ep1 Q; w1 QI EQs 1
c Q
EQs 1 c:

A3

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619

Comparing Eqs. (A1) and (A2) yields

Ep1 Q; w1 QI EQs 0
c
Ep1 Q; w1 QI 0 1
nz > 0;
A4
bz > 0:
It follows that w1( Q)I = 0 cannot be an equilibrium, when EQ(s)
c>0. Hence, the
equilibrium initial offer is w1( Q)I*= EQ(s = 0)
c.
Comparing Eqs. (A2) and (A3) yields
Ep1 Q; w1 QI EQs 0
c
Ep1 Q; w1 QI EQs 1
c
1
nEQs 1
EQs 0
nz:

A5

If Eq. (A5) is positive, then w1( Q)I*= EQ(s = 0)
c and w1( Q)R*= EQ(s = 1)
c, if
the outside offer is EQ(s = 1).
Now consider the case in which EQ(s = 1)
c>0 z EQ(s = 1)
c. The two possible
strategies are: (w1( Q)I = 0, w1( Q)R = EQ(s = 1)
c) and (w1( Q)I = EQ(s = 1)
c). (In
the latter case, no counter-offers are necessary).
Ep1 Q; w1 QI 0 np1 Q; w1 QI 0; w1 QR EQs 1
c
1
np1 Q; w1 QI 0 Q
nEQs 1
nc
nz:
Comparing Eqs. (A3) and (A6), we get

A6

Ep1 Q; w1 QI 0
Ep1 Q; w1 QI EQs 1
c

1
nEQs 1
c
nz:

A7

If Eq. (A7) is positive, then w1( Q)*=(0, EQ(s = 1)
c) is the equilibrium strategy.
Case 1: Substituting n = r and Q = L into Eq. (A7) yields the required expressions.
When ca[0, d(H
L)), note that paying the worker EQ(s = 1)
c would yield strictly
negative profit for all z>0. When c>EQ(s = 1), high mobility costs guarantee retention
of both worker types.
Case 2: Substituting n = q and Q = H into Eqs. (A5) and (A7) yields the required
expressions for the two cost ranges. For any c z 0, note that it is always profitable to
retain the H-type worker.
5
Proof of Proposition 3. First, note that F2 offers expected output based on the signal
received, i.e., w2(s = 1)*= EQ(s = 1) or w2(s = 0)*= EQ(s = 0).
(a) Low switching costs: ca[0, EQ(s = 0)). Note that EQ(s = 1)
c>EQ(s = 0)
c>L, for
ca[0, c0). Since F1s wage offer never exceeds the productivity of the worker, then
w1(L)*= w1la[0, L]. Consequently, F1 can never retain an L-type worker. For ca[c0,
EQ(s = 0)), EQ(s = 1)
c>L>EQ(s = 0)
c. In this cost range, w1(L)*= EQ(s = 0)
c

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and F1 retains an L-type worker only if F2 receives s = 0, which occurs with probability
(1
r).
To determine F1s wage offer to an H-type worker, it is necessary to compare the
expected profit for the wage offers EQ(s = 1)
c and EQ(s = 0)
c. If w1(H ) <
EQ(s = 0)
c, then F1 loses the H-type worker with certainty. The wage offer that
retains an H-type worker with certainty is w1(H ) = EQ(s = 1)
c. So w1(H )*a
{EQ(s = 1)
c, EQ(s = 0)
c}. If F1 offers w1(H ) = EQ(s = 0)
c, it retains an H-type
worker only if F2 receives s = 0, which occurs with probability (1
q). Hence,
Ep1 H; wHI EQs 1
c H
EQs 1 c

A8

Ep1 H; wHI EQs 0
c 1
qH
EQs 0 c:

A9

Equating the difference between Eqs. (A8) and (A9) to zero and solving for c, we get
cA

d
c
q1
c
H
L:
q

A10

If ca[0, cA), then Ep1(H, w(H)I = EQ(s = 0)
c) z Ep1(H, w(H)I = EQ(s = 1)
c), so
that w1(H)*= EQ(s = 0)
c and F1 loses the H-type worker with probability q. If
ca[cA, EQ(s = 0)), then Ep1(H, w(H)I = EQ(s = 0)
c) V Ep1(H, w(H)I = EQ(s = 1)
c)
and w1(H)*= EQ(s = 1)
c and F1 retains the worker. Finally, note that if cA z
EQ(s = 0), then w1(H)*= EQ(s = 0)
c and if cA V 0, then w1(H)*= EQ(s = 1)
c.
(b) Moderate switching costs: ca[EQ(s = 0), EQ(s = 1)). First, consider F1s wage offer
to the L-type worker. Since EQ(s = 1)
c>L, for c < c1, and assuming that
c1 < EQ(s = 0), F1 offers w1(L)*= 0.15 It follows that an L-type worker remains with
F1 only if F2 receives s = 0, which occurs with probability (1
r).
For the cost range ca[c1, EQ(s = 1)), L z EQ(s = 1)
c>0. Therefore, the lowest
wage offer that will retain the L-type worker is 0, i.e., if F2 receives s = 0, which
occurs with probability (1
r). The maximum wage offer that will retain the L-type
worker with certainty is EQ(s = 1)
c. Therefore, w1(L)*a{0, EQ(s = 1)
c}. So
the analysis of F1s equilibrium wage offer to an L-type worker involves comparing
the expected profit for the wage offers 0 and EQ(s = 1)
c.
Ep1 L; w1 LI EQs 1
c L
EQs 1 c

A11

Ep1 L; w1 LI 0 1
rL:

A12

Subtracting Eq. (A12) from Eq. (A11), equating to 0 and solving for c, we get
cC dH
L 1
rL:

A13

15
Comparison of EQ(s = 0) and c1 is algebraically intractable. For simplicity, we assume that c1>EQ(s = 0).
Assuming that EQ(s = 0)>c1 adds to the number of equilibria, without yielding any further insights. Within each
cost range, there are a number of sub-intervals and, hence, a number of possible equilibria. The assumption that
EQ(s = 0) < c1 leads to fewer sub-intervals and fewer possible equilibria. The insights gained are virtually identical
and the results obtained are less repetitive.

D.S. Banerjee, N. Gaston / Labour Economics 11 (2004) 599622

621

Also, note that

EQs 1
cC rL > 0 Z cC < EQs 1:

A14

cC
c1 L > 0 Z cC > c1 :

A15

By assumption, c1
EQ(s = 0)=(d
c)(H
L)
L>0, so EQ(s = 1)>cC>EQ(s = 0).From

Eqs. (A14) and (A15), we get cCa[c1, EQ(s = 1)). In the cost range ca[c1, cC), Ep1(L,w1
(L)I = 0)>Ep1(L,w1(L)I = EQ(s = 1)
c), so that w1(L)*= 0. In the range ca[EQ(s = 0),
cC),w1(L)*= 0. In the range ca[cC, EQ(s = 1)), Ep1(L,w1(L)I = 0) V Ep1(L,w1(L)I = EQ
(s = 1)
c and w1(L)*= EQ(s = 1)
c.
The analysis for F1s wage offer to an H-type worker once again involves comparing
the expected profit for the wage offers EQ(s = 1)
c and 0. In the latter case, it retains
the H-type worker only if F2 receives s = 0, which occurs with probability (1
q).
Hence,
Ep1 H; w1 HI EQs 1
c H
EQs 1 c

A15

Ep1 H; w1 HI 0 1
qH:

A16

Subtracting Eq. (A16) from Eq. (A15), equating to 0 and solving for c, we get
cB d
qH 1
dL:

A17

Also, note that cC
cB = qH
rL>0, because q>r and H >L. Therefore, we get
EQs 1 > cC > cB :

A18

Comparisons of cB and c1 as well as cB and EQ(s = 0) are intractable. However, if

ca[EQ(s = 0), cB), then Ep1(H, w1(H)I = 0)>Ep1(H, w1(H)I = EQ(s = 1)
c), so that
w1(H)*= 0. F1 retains the H-type worker with probability only if F2 receives s = 0, which
occurs with probability (1
q). If ca[cB, EQ(s = 1)), then it follows that Ep1(H, w1(H)I =
EQ(s = 1)
c) z Ep1(H, w1(H)I = 0) and w1(H)*= EQ(s = 1)
c. Hence, F1 retains the
worker. Finally, note that if cB < EQ(s = 0), then w1(H)*= EQ(s = 1)
c and F1 retains
the H-type worker with certainty.
(c) Prohibitive switching costs: c z EQ(s = 1). We have EQ(s = j)
c V 0, j = 0, 1, so that F1s
F1s wage offer is (w1(H)*, w1(L)*)=(0,0) and workers of both types are retained with
certainty.
5
Proof of Lemma 1. First, note that EQ(s = 0)
cA=(qH
(d
c)(H
L))/q and EQ
(s = 0)
cB = qH
(d
c)(H
L). It follows that qH
(d
c)(H
L)>0 Z cA < EQ(s = 0)
Z cB < EQ(s = 0) and cB < EQ(s = 0) Z cA < EQ(s = 0). Next, note that if qH
(d
c)
(H
L) V 0 Z cA z EQ(s = 0) Z cB z EQ(s = 0) and cB z EQ(s = 0) Z cA z EQ(s = 0). The
proof of part (iii) is contained in the proof of Proposition 3.
5

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D.S. Banerjee, N. Gaston / Labour Economics 11 (2004) 599622

Proof of Proposition 4. The separating equilibrium does not exist, so consider the pooling
equilibrium, i.e., w1( Q) = w1l, Qa{L,H}, w1lawl. We have r( Q = Hjs = w1l) = p and
r( Q = Ljs = w1l)=(1
p). Let EQ(s = w1l) = EQ(s) denote F2s expected productivity of the
worker, given F1s wage strategy. Clearly, F2s equilibrium offer is w2(s = w1l)*=
EQ(s) = L + p(H
L). If the worker switches to F2, his payoff is EQ(s)
c. F1s maximum
wage offer is L to any worker. So the minimum switching cost, cmin, that can guarantee a
pooling equilibrium satisfies EQ(s)
cmin = L, i.e., cmin = p(H
L). If c>EQ(s), then the
payoff to the worker from switching is 0; therefore, w1( Q)*= 0 and the worker stays with
F1. If ca[cmin, EQ(s)], then EQ(s)a[cmin, L]. In this case, F1 can retain the worker by
offering EQ(s)
c, i.e., w1( Q)*= EQ(s)
c. Finally, note that, since F2 offers EQ(s) to all
workers and since it is profitable for F1 to retain all workers for w1( Q) V L V Q, then F1s
equilibrium wage offers are the same for all z>0.
5
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