Screening, overconfidence, and competition’s effect on market efficiency

Abstract

This paper examines the relationship between competition and efficiency in a labor market in which worker effort is not observed by firms, workers have private information about their productivity, and workers overestimate their productivity (overconfidence). Firms solve a contracting problem that involves trade-offs between efficiency, rent-extraction, exploitation of overconfidence, and competing with other firms for the services of workers. Regardless of the degree of competition, high-type effort is overincentivized, while low-type effort is non-monotonic in the degree of competition and may be at, above, or below the efficient level, depending on the degree of competition and distribution of types in the market. Efficiency losses are strictly positive, non-monotonic in the degree of competition, and are minimized in monopsony if low types are common enough, whereas an intermediate degree of competition minimizes efficiency losses otherwise. Worker preferences over market structures and the effects of debiasing workers on market efficiency are also discussed.