Competition in Salaries, Credentials, and Signaling Prerequisites For Job (A J) 1976

Competition in Salaries, Credentials, and Signaling Prerequisites for Jobs
Author(s): Michael Spence

Source: The Quarterly Journal of Economics, Vol. 90, No. 1 (Feb., 1976), pp. 51-74
Published by: Oxford University Press
Stable URL: http://www.jstor.org/stable/1886086
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COMPETITION IN SALARIES, CREDENTIALS, AND
SIGNALING PREREQUISITES FOR JOBS *
MICHAEL SPENCE
I. Introduction, 51.-II. The choice of behavioral hypothesis, 53.-

III. Assumptions, 54.- IV. Analysis of equilibria, 55.- V. Comparison with
the passive-response equilibria, 63.- VI. Specialized firms, 63.- VII. Equi-
libria with complementary factors, 66. - VIII. Concluding remarks, 72.-
Appendix A: Summary of the passive-response model, 73.- Appendix B:
The elimination of dominated, passive equilibria, 73.
I. INTRODUCTION
In previous models of signaling in job markets, it has been as-

sumed that employers read potential signals, such as education,
interpret them in the light of past experience with the relationship
between the signal and individual productivity, and respond under
competitive pressure by offering to pay people their expected pro-
ductivity or worth to the firm, conditional on the signal. The in-
dividual employer (and employers together) affects employee sig-
naling decisions and hence the observed relationship between the
signals and productivity. However, the behavioral assumption
stated above concerning employer responses to signals explicitly
excludes the possibility that employers anticipate the effects of their
own responses upon the signaling decisions of potential employees
and hence upon the relationship between signals and productivity.
Thus, for example, employers read education as a signal of
productivity, but the content of the signal is determined by the pat-
tern of investment in it by individuals, and that in turn is determined
in part by the way it is rewarded in the market. Finally, the rewards
to the signal in the market are determined by how it correlates
with individual productivity. That completes the loop.
It has been suggested that in some markets the receivers of the
signals may know what effect their responses to signals will have on
their informational content. If they do, then they will compete on
this dimension as well as on wages and salaries. It has also been
* This work was supported by National Science Foundation Grants GS-

40104 and GS-39004 at the Institute for Mathematical Studies in the Social
Sciences, Stanford University. I am grateful to Bruce Dieffenbach, David
Starrett, and the referees for comments. I have also benefited from exposure to
the general theorem of Rothschild and Stiglitz, establishing the impossibility
of pooling people in different risk classes in insurance markets.
52 QUARTERLY JOURNAL OF ECONOMICS
suggested that this more sophisticated behavior by receivers of

signals will alter the nature of the equilibria in the market and
eliminate the inefficiency associated with the equilibria in the market
with more passive receivers.
In an appendix to Spence 1 sophisticated responses by receivers
are investigated, but the analysis is incomplete in some respects.
This paper examines the properties of market equilibria when the
receivers of signals compete on the signaling dimension as well as in
the area of monetary rewards. In job markets this means that em-
ployers compete with respect to the credentials or the signaling
prerequisites for jobs as well as with salaries.
When receivers of signals simply read them in the light of past
experience in the market, I shall characterize the response as passive.
When they anticipate the effect of their own responses on the pat-
terns of investment in the signal and attempt to compete in this
dimension, I shall call the receiver response active.
There are two questions one can ask about these alternative
behavioral assumptions. One is which is the more reasonable and
under what circumstances? The second is by how much are the
properties of market equilibria different in the two cases? The
latter amounts to asking what difference it makes. I should like to
make some remarks about the first question, and then spend the re-
mainder of the paper discussing the properties of equilibria under
the active-response hypothesis.
The principal conclusion of the analysis is that the equilibria
in the active-response model are a subset of those equilibria in the
passive-response case, which are not Pareto-inferior to some other
passive-response equilibrium. More concisely, the active-response
equilibria are a subset of the Pareto undominated passive-response
equilibria. This fact has two implications. Competition in signals
eliminates some of the inefficiency 2 of the passive-response case.
But in the passive-response case there is a tendency for there to be
overinvestment in the signal in all the equilibria. This overinvest-
ment results from the fact that the private return to the signal in
the market exceeds its direct contribution to productivity. This in-
efficiency is not eliminated by competition in the signaling dimen-
sion. That is the implication of the active-response equilibria's
being a subset of equilibria in the passive-response case.
1. M. Spence, Market Signaling: Information Transfer in Hiring in Re-

lated Processes (Cambridge: Harvard University Press, 1973); or "Job Market
Signaling," this Journal, LXXXVII (Aug. 1973), 355-74.
2. Associated in ibid. with multiple equilibria.
SIGNALING PREREQUISITES FOR JOBS 53
II. THE CHOICE OF BEHAVIORAL HYPOTHESIS
The active-response hypothesis has two informational under-

pinnings. One is that the receivers (from here on I shall use the
job market and refer to employers) know the informational struc-
ture of the market. In particular, they know in a general way that
the relation between signals such as education and productivity may
change if and when the salary schedules that determine the returns
to education change. In other words, employers know that educa-
tion is a signal, that there are other attributes of individuals that
partially determine productivity, and that these are being captured
in the signal.
However, in order to compete effectively, employers must know
more than this general information. They must also know or ac-
curately predict the relation between education and productivity
that will appear in the group that is hired for any schedule of
salary offers, given the schedules of their competitors.
The active-response hypothesis, therefore, imputes a consider-
able amount of information to the receiver of signals. Under certain
circumstances such an imputation may not be unreasonable. In a
market where there is one important signal, one might expect em-
ployers to have acquired this information through experimentation
and experience in the market. In the structurally similar case of
insurance markets with adverse selection, where the signal is simply
which policy the individual chooses, the hypothesis seems quite
reasonable.3 It is, after all, the business of insurance companies to
determine the composition of risk among buyers, given any menu
of policies offered by the company. However, in some job markets
the signals are both many and complicated. Therefore, it seems to
me less reasonable to presume that the information required for
active competition in the sense defined above, is available to the
employers.
Ideally the information available to the receivers should be
made endogenous to the model and be predicted or explained on the
basis of rational search by employers and the history of the market.
For reasons of analytical complexity this more satisfactory middle
ground is difficult to occupy. In the absence of a definitive model,
one is required to make intuitive strategic choices of behavioral
3. The insurance case with adverse selection is treated in great generality

in the interesting paper by M. Rothschild and J. Stiglitz, "Adverse Selection and
the Non-Existence of Equilibrium in Insurance Markets," unpublished paper,
April 1973.
hypotheses, based upon the types of complexity considerations dis-

cussed above.
There is another methodological strategy available, and that is
to investigate the operational difference between the two hypotheses
with respect to properties of the market equilibria that are of con-
cern. The remainder of this paper is devoted to such a comparative
investigation. Passive-response equilibria have been studied in
Spence.4 Therefore, most of the substance of what follows concerns
the characteristics of equilibria in the active-response model.5
The conclusion is that the equilibria in this model form a subset
of the equilibria in the same market without competition on the
signaling dimension. Some of the more inefficient passive-response
equilibria are eliminated. However, the tendency to induce indi-
vidual overinvestment in the signal persists.
III. ASSUMPTIONS
I shall assume that there are identical firms and only two differ-
ent types of people. There is a continuous scalar signal y, which is
purchased by individuals. Each firm has two jobs, indexed by j.
fij (y) = the productivity of a person of type i with the signal
y in job j, in either firm.6
Signals affect productivity as does the individual's type. Produc-
tivity is not affected by the number of others of either type em-
ployed by the firm.7 The proportion of people of type i is qj, i= 1,2.
The second group, i=2, is assumed to be the more productive in the
following sense. In job 1, the lower skilled one,
f21 (Y) ?fl1 (Y) for all y.

Second, in job 2, the more skilled one,
f22 (Y) ?f12 (Y) -

Finally, f1l (Y) <112(Y), so that the less skilled are always more
4. Spence, op. cit.

5. An early attempt to deal with competition in the realm of job prereq-
uisites is in an appendix to Spence, op. cit. More recently, J. K. Salop and
S. C. Salop, "Self-Selection and Turnover in the Labor Market," unpublished
paper, December 1972, under the heading of self-selection, deal with separating
employees with different propensities to quit by offering different intertemporal
salary schedules.
6. Note that the signal may contribute to the individual's productivity
or worth to the firm. As such, it may legitimately be referred to as human
capital. This does not mean that it is not also a signal.
7. The production is additively separable and linear in the labor inputs.
I shall drop this assumption later in considering the impact of complementarity
between inputs.
productive in the low-skilled job than they are in the high-skilled

one. For the second group education may be necessary to perform
the second job, in the following sense:
f21 (Y) > f22 (y) for y < y",

and
f21 (Y) <f22 (y) for y > y".
We further define f, (y) and f2 (y):
fj (y) =max fj(y), i= 1,2.
The quantity fj (y) will be referred to as the productivity of gro

at signal level y. Some of the analysis to follow will depend upon
fi (y), i = 1,2, and not the underlying fij (y).
There are signaling costs of c+(y) for group i at signal level y.
It is assumed that c'1(y) >c'2(y) and that c1(y) >c2(y) for all y.8
Each firm makes wage offers, individuals select their preferred
firms and signal levels, and are hired. The argument here is devoted
to locating the equilibria and describing their properties. Directly
writing out the conditions characterizing an equilibrium is both
messy and, by itself, uninformative. It is desirable to short-cut the
analysis. Since initial interest attaches to the wage offer schedules
that the employer makes, the strategy employed here, to put it
somewhat crudely, is simply to consider a variety of possible wage
offers for a representative employer and to determine for each such
possibility whether or not a competitor could attract some or all of
his employees with a different schedule and still make a profit. This
will lead by elimination to equilibrium configurations in the market
and to a variety of distinct possible cases.9
IV. ANALYSIS OF EQUILIBRIA
The basic diagram is shown in Figure I. On it are plotted fi(y)

and ci (y) for i= 1,2. Wage offers are shown by step functions with
dotted lines. One such appears in Figure I. Suppose that an employer
offered a schedule like that shown in Figure I. Without any com-
petition or with competitors offering the same schedule, he would
make a profit. Individuals select y to maximize w (y) - ci (y). Mem-
bers of group 1 would select Yl, receive w1, and have productivity
f (yi) > w1. Similarly for group 2. But a competitor could spirit
8. It is assumed that cd(y) is convex, i=1, 2.

9. The equilibria are Nash equilibria, situations in which each firm's
wage offer schedule is optimal given those of the other firms.
C, (y)
/f(y)
FIGURE I
PRODUCTIVITIES AND SIGNALING COSTS
away all his employees by raising w, and w2 slightly and still make
a profit.
PROPOSITION 1. If two groups signal differently, each will receive its

productivity as wages in a competitive equilibrium, and more
generally, any collection of people with the same signal will
receive its average productivity."'
It is worth noting that we need consider only step functions

precisely because all that matters is the productivity at the level of
the signal actually selected and that will equal the wage.
Now consider an offer of the type shown in Figure II. At the
signal levels yj and Y2, selected by groups 1 and 2, wages equal m
ginal products. There is no question of another employer outbidding
on wages alone. However, a competitor willing to shift yj and Y2
as well as w1 and w2 may be able to attract the labor force. This,
incidentally, is the behavior that is excluded in passive-response
models. The point is that at neither yj nor Y2 in Figure II is th
return of a member of the relevant group maximized. For reasons
that will be apparent shortly, I shall concentrate on group 1. In
10. It is this basic property of competitive equilibria that makes the final
outcome inefficient. In M. Spence, "Competitive and Optimal Responses to
Signals: An Analysis of Efficiency and Distribution," Journal of Economic
Theory, VIII (March 1974), 296-332, it is shown that efficiency is achievable;
but usually wages have to deviate from marginal productivities.
C, (y)
/C2(Y) f2 ( y)
Y)
Yl Y2 Y
FIGURE II
Figure III yj is shifted to the level at which fI(y) -cl(y) is max-

imized, and w, is slightly below f, (y). If a firm offered the schedule
shown in Figure III, it would attract all of group 1 away from firms
offering the schedule in Figure II. It would also make a profit.
PROPOSITION 2. The lower productivity group will signal at the

efficient level in an equilibrium, provided that the two groups
are signaling differently."1
w
C, (y)
/~~~~f t(Y)
ww, X *~~ ~ ~ ~Y)

W2~ ~~ W 2(Y
WI~ ~ I
y, Y2 Y
FIGURE III
11. "Efficient" simply means "that which maximizes output net of signal-
ing costs."
A similar argument can sometimes be made for group 2, the

more skilled people, but there is a potential snag. It is here that one
begins to find cases. Figure IV illustrates an offer schedule that in-
duces each group to invest in the efficient levels of yi, i= 1, 2. Each
w
f2( Y)
C, (Y)/
W20 Av-fW (~~~~~~~C?(Y)
w2
,~~~~~~~~~~~~~f ,_ ,
Y. Y2 Y
FIGURE IV
receives wages equal to productivity. In particular, it is to be noted

that at Y2 the net return to group 1 is less than it is at y,, so that
members of group 1 have no incentive to imitate the signaling be-
havior of members of the second group. Subject to some further
argument, we may tentatively state the following proposition.
PROPOSITION 3. Efficient levels of investment in the signal and com-

petitive wages can sometimes be achieved as a signaling equi-
librium.'2
We turn now to a case in which the snag occurs. In Figure Va

the wage offer schedule has its steps at the efficient levels Yi and
Y2. But members of group 1 will rationally select Y2. The firm that
makes this offer will therefore lose money, and the schedule shown
will not in general be part of a market equilibrium. Moreover, the
signal would not carry information in such a situation, since every-
one selects Y2. This may further reduce output by removing the
12. To complete the argument, we have to consider a competitor who

offers a uniform wage to everyone, at some level of y. This is best left until
later.
W Cl (yf
/ BY)
V i m I ~~~(Y)
W2
WI
yI Y2 Y
FIGURE Va
employer's ability to allocate high-productivity people to the more

skilled jobs.
In Figure Vb Y2 has been moved to the right to a point where
it is no longer rational for members of group 1 to set Y = Y2. Wages
equal group 2's productivity at that point. The level Y2 is above the
efficient level for members of group 2. The two groups rationally
invest in different levels of y, and the signal carries information.
It is fairly clear that no other wage offer that induces distinct levels
of investment in y for the two groups will dominate this one without
causing the exit of at least one group from the firm that makes the
different offer.
In Figure Vb we have put group 1 at its efficient point and then
pushed group 2 up in terms of its investment in y to a point that (a)
exceeds efficiency and (b) removes the incentive for imitation by
group 1. One can ask whether one might not put group 2 at an
efficient point and reduce Yi. This cannot be done. The two groups
are not symmetrically situated in this respect. If yi is reduced, Y2
must be increased even more to maintain differential levels of in-
vestment because lowering Yi reduces the net return of group 1.
Such a move would be inferior for the entire labor force and hence
cannot be competitive.
PROPOSITION 4. The wage schedule shown in Figure Vb is the only

wage schedule that is consistent with (i) competition, (ii) each
firm's hiring both groups, and (iii) differential choice of y by
W C, (y)
cf2(Y)
f I,(y)
W2t - W y
WI
y
Y.y
Y2 Y
FAGURE Vb
the two groups (and hence information being carried by the

signal).
I hasten to add that we have not yet shown the schedule in

Figure Vb to be an equilibrium but only that it is the only candi-
date with the above three properties.
Let us refer to a situation in which a firm hires only one type
of person as specialization. With the separable production function
that I have been using for expositional purposes, firm specialization
is entirely possible. However, if the types of people were comple-
mentary inputs, specialization would either be impossible or less
attractive. Therefore, in anticipation of dealing with complemen-
tary inputs later and in order to keep different influences on equi-
libria separate, let me simply temporarily disallow firm specializa-
tion by fiat, and consider whether there is a one-step wage-offer
schedule that attracts both groups and defeats the schedule shown
in Figure Vb. Note that a one-step schedule will cause everyone
to invest in the same level of y, and property (iii) in Proposition 4
will not hold. Therefore, we are dropping requirement (iii) tem-
porarily and retaining requirement (ii).
An employer might try to compete by offering the same wage' at
a certain level of y to everyone. That is to say, one must consider
offered wage schedules with only one step.
If the world were as in Figure IV, where both groups are at their
efficient points, a one-step schedule would never be competitive be-

cause the return to group 2 would be lower. But in Figure Vb, a one-
step schedule might be viable. The reason is that a one-step schedule
could raise group I's return by increasing their ex ante expected
productivity when lumped in with group 2. It could also increase
group 2's return by cutting out excessive signaling costs incurred
at Y2 in Figure Vb. We now proceed more formally.
Suppose that a one-step schedule is introduced with one step at
y. Information is lost. Average output per employee will be
f (y) = max [Y.qjfij (y)]
I i
It is assumed that the firm hires people in proportion to the numbers
of people of each type in the population. Figure VI is Figure Vb
fc(y)
Y Y, YM Y Y2 Y
FIGURE VI
with a graph of f (y) superimposed on it. Because of the assumptions

about the fjj (y) made earlier, f (y) will lie between f, (y) and f2 (Y)
as shown.
Inspection will indicate that as drawn, any y* in the interval
(y',y") will serve as the step point in a one-step schedule w* (y)
that increases the net return of both groups relative to w(y). The
endpoints are set by the constraint that each group must be better
off than with w (y). That is, any y* satisfying
f(Y*)-c.(y*) >wi-ci(yi), i- 2
will do. It is an interval because of the implicit assumption that the

fi(y) and f(y) are concave and the cj(y) convex. It is of course
possible that there is no such y*.
The height of f (y) and the rates of rise of the cj(y) determine
whether the interval is empty. The height of f (y) is associated with
the expected value of the information carried by the signal when
it in fact enables the employer to distinguish people. The higher the
value of the information, the lower is f (y), and the less likely is
there to be a y* making everyone better off, for the loss of informa-
tion with the one-step schedule is accompanied by a reduction in
average productivity, output, and average wages.
PROPOSITION 5. Excluding the possibility that firms specialize by

type of labor, the two-step schedule in Figure Vb is the unique
equilibrium if for all y and ilk:
f (Y) -Ci (Y) > f i (Yi) - C (yI) O--f (Y) -Ck (Y) < fk (Yk) - Ck (Yk)-
However, if a one-step schedule is preferred by both groups, or

rather an interval of one-step schedules, one must ask which of
them will be selected under competitive pressure. One can answer
this question if specialization continues to be excluded. Consider
Figure VI again. As one moves the step point from y' to y*, group
1 loses, and 2 gains. Movement to the right of y* causes everyone to
lose. Any point in [y',y*] is a possible equilibrium step point. For
once it is settled on by all firms, a movement away from any such
point will cause specialization. In general, on some subset of the
interval (y',y"), the two groups will rank order step points op-
positely. The equilibria are on this subset.
PROPOSITION 6. Excluding firm specialization in labor types, we see

that one-step equilibrium wage offers are possible, and when
they exist, there will typically be a continuum of them.
To summarize the discussion thus far, we have three types of

nonspecialized equilibria:
(1) Two-step, full-information schedules that induce efficient
investment in the signal;
(2) Two-step, full-information schedules that induce efficient
investment by group 1 and overinvestment by group 2;
(3) One-step, no-information schedules, where investment is
efficient for neither group.
They are mutually exclusive; their occurrence depends upon the
structure of the productivity and cost functions. If, for example,
the signal does not contribute to the productivity of individuals in

the higher productivity group, then equilibria of type 1 are impos-
sible, because the efficient level of Y2 would be zero.
V. COMPARISON WITH THE PASSIVE-RESPONSE EQUILIBRIA
This preliminary categorization of equilibria invites compari-

son with the case in which the receivers of signals simply read them.
Provided that wages equal expected marginal products given the
signaling decisions of individuals, there is an equilibrium in the
passive-response market. Since this is one of the requirements of an
equilibrium with active responses, the equilibria in the active-re-
sponse case are a subset of those in the passive-response model.
A schedule like that depicted in Figure II is an equilibrium
schedule in the passive-response model. Wages equal productivities,
and the two groups rationally select yj and Y2, respectively. It is
not, however, an equilibrium in the model in which employers
compete in the realm of credentials because neither group is maxi-
mizing net income. In fact, it is fairly clear that there is a schedule
that improves the net income of both groups over the levels in
Figure II. More generally, the equilibria in the passive model can
be partially ordered by the Pareto criterion.
The effect of competition in the credentials dimension is to
eliminate from the set of possible equilibria in the passive model
those schedules that are Pareto-inferior to some other schedule. In
the example studied thus far there may be only one Pareto un-
dominated equilibrium. Later, in examining less special production
functions, we shall find that this is not a general property.
It is to be emphasized that elimination of Pareto. dominated
equilibria does not guarantee full efficiency in the active-response
model. In Figure Vb group 2 sets Y2 above the net income-maximiz-
ing level. To escape from this kind of overinvestment in the signal,
wages have to be allowed to deviate from marginal products.'3 But
such deviations are inconsistent with competition.
VI. SPECIALIZED FIRMS
I want now to return to the possibility that firms may hire only
one type of person. When there is a symmetric equilibrium of type 1,
there is little competitive incentive to specialize. Hence specializa-
13. See Spence, "Competitive and Optimal Responses to Signals: An

Analysis of Efficiency and Distribution."
tion is unlikely to be observed. It is not, however, logically impos-

sible. In fact, the proportion of each type in each firm is indeter-
minate because of the additivity and linearity of the production
model.
Similarly in equilibria of type 2 a decision to specialize gains
a firm nothing against a wage offer of the type shown in Figure Yb.
One cannot improve the position of group 1 and make a profit. And
to improve the position of group 2, one would have to lower Y2, in
which case there would be an influx of group-i people setting Y=Y2,
and negative profits for the firm. Again specialization is not logically
impossible, just not very interesting. A firm could take only group
1 at Yi, or only group 2 at Y2. But it is not implied by the model.
With a separable production function and constant returns to scale,
the equilibrium allocation of people to firms is indeterminate.
In one-step equilibria of type 3, the situation is considerably
different. If we allow firms to make moves that attract only one of
the two groups, then with a separable production function, one-step
wage offer schedules can never be found in an equilibrium.'4 In
Figure VI a one-step schedule is depicted that cannot be defeated by
any two-step schedule that attracts both groups. But if we allow
a firm to attract only one group, then there is a schedule that (1)
attracts group 2 and (2) does not attract group 1.
Consider Figure VII. The familiar curves depicting c (y) and
fM(y), i= 1,2, are shown as well as f (y). There is a one-step sche
OAXZ. Suppose that all firms were offering this schedule. Next
we draw the indifference curves for the two groups through A. Since
individual welfare is measured by net income, the indifference
curves for each group are just families of curves parallel to their
respective signaling cost functions. In particular, the segment AMB
is part of the indifference curve of group 1 through A. Similarly,
ANC is part of the indifference curve of group 2, also passing
through A. They meet f2(y) at M and N, respectively.
Now suppose that the schedule OYPR is offered by some firm.
P lies above ANC so that group 2 will switch to that firm. But P
lies below AMB so that group 1 will remain with the firms that they
started with. All of the latter will lose money, and with P slightly
below f2 (Y) the deviating firm will make a profit. Because c1 (y) is
14. This property is an instance of the general theorem of Rothschild

and Stiglitz, op. cit., for insurance with adverse selection. The high- and low-
risk people will never be pooled in an equilibrium. There is always a policy
that attracts the low-risk people but not the high-risk types. I am grateful
for having heard the Rothschild-Stiglitz result presented; it prevented me from
making an error in the analysis here.
X Y Y
FIGURE VII
steeper than c2(y), the indifference curves of group 1 will always be

steeper than those of group 2. Therefore, the segment MN on f2 (Y)
will always exist. Moreover, the region AMN will have an interior.
Therefore, there is always a one-step schedule that attracts group
2 away from any one-step schedule and makes a profit.
PROPOSITION 7. If firm specialization is consistent with the produc-

tion function, then there does not exist an equilibrium in which
the two groups select the same level of y and receive the same
wages or salaries.
From Proposition 4 the only two-step schedule that is a candi-

date for equilibrium is the one that puts group 1 at its efficient point
and group 2 at either its efficient point or the minimum level of y
needed to keep group 1 out, whichever is larger. Call this schedule
w* (y). Sometimes there is a one-step schedule that is preferred by
both groups to w*(y). And from Proposition 7 if specialization is
allowed, no one-step schedule is ever an equilibrium.
PROPOSITION 8. If there is a one-step schedule preferred by both

groups to w*(y), then there is no equilibrium in the market.
And if there is an equilibrium in the market, it is the two-step
schedule w* (y).
This argument depends upon there being both separability and

constant returns in the production function. Of these, complemen-
tarity is the more important. For it is obvious that with sufficient
complementarity between groups as inputs, specialization will not
be a competitive move for a firm. The extreme case of course occurs
when a firm needs people of both types to produce anything.
With specialization excluded by complementarity, market
equilibria will have the characteristics described in propositions 1
through 6. Both one- and two-step schedules are possible. Which
obtains depends upon the structure of the production and cost func-
tions. If the signaling costs of group 1 rise much faster than those of
group 2, then the two-step equilibrium is more likely, as is the situ-
ation in which group 2 is also at its efficient point. With diminishing
returns the allocation of labor by numbers within each type will
cease to be indeterminate. But that is the result of ordinary com-
petitive forces and has inherently nothing to do with informational
gaps.
There remain some interesting new features of equilibria in
the case of complementary inputs, to which we now turn.
VII. EQUILIBRIA WITH COMPLEMENTARY FACTORS
Firms are assumed to be identical for simplicity. Let q.z=the

number of people of type i employed by firm z, and y~z the signal
carried by this group. The production function is written as
XZ = f (q1z~q2zzy1zYy2z),
so that output depends upon both the numbers and the signal levels
of both groups. Both groups are required for production, so that
Xz = 0 if either q1Z = 0 or q2Z = 0. The marginal product of group i
is
M.Z $ af
The marginal product m~z is assumed to diminish with qqZ. Increases
in y~z increase the marginal products of both groups, but at diminish-
ing rates.
In an equilibrium each group will divide equally over firms.
Otherwise, one firm could profitably expand at the expense of the
others. Wages will equal marginal products (expected or actual
depending upon whether ylZ and y2Z are distinct). And since
firm has to attract both groups to produce, the return to individuals
net of signaling costs must be the same. This fact in conjunction
with the previous two points implies that the levels of yiZ and Y2Z
must be the same over firms as well. Therefore, we can look for
equilibria by searching for wage schedules for the representative
firm that stand up under competitive pressure. Henceforth, I shall
drop the superscript z.
The problem is to locate pairs (Y1,Y2) (and corresponding wages
that will be equal to marginal products) with the following property:
no other pair attracts both groups and makes a profit. Actually it
is not profits that matter. All that is necessary is that no other
pair with wages equal to marginal products attracts both groups.
The natural way to conduct this search seems to be to depict
the indifference curves of the two groups in the plane with Yi and Y2
on the axes and then simply look for those points, movement from
which reduces the net income of at least one of the groups. The
result is a contract curve, shown in Figure VIII, along with in-
y2
indifference curves
\Y~~~~~~~y
Ye
FIGURE VIII
difference curves for both groups. Points on an indifference curve

for a group satisfy an equation of the form, m-- ce (ye) = a constant.
Implicitly, people are divided evenly over firms. Thus for group 1,
for each level of Y2, there is an optimal level of Yi, where the relevant
indifference curve is horizontal. A dotted line passes through these
conditionally optimal points. Since increases in Y2 benefit group 1
and at no cost, the higher curves are preferred to the lower. Sim-
ilar remarks apply to the second group.
Also shown in Figure VIII are the tangencies of the in

curves, the line XYZ. These points are logical candidate
libria because any movement off his curve hurts at least one
group. For any point off XYZ there is a point on XYZ that is pre-
ferred by both groups.
We now superimpose upon Figure VIII the constraints that
ensure that each group selects the appropriate level of y. From the
previous analysis we know that these constraints can be binding and
that they place restrictions upon the range of possible equilibria.
The two constraints are
m,- c, (My) ='- Irnj - C (yj),
for i/=j, ij = 1,2.
Figure IX depicts the "contract curve" XYZ and the boundaries
of the two constraint sets. The shaded area is the set of points
consistent with the individual choices.
Y2
yI
FIGURE IX
Suppose that all firms were located at a point like A on the

contract curve in the shaded region. Any other feasible two-step
schedule, which might be offered, will attract at most one of the
groups, thereby hurting the firm that makes the offer and the other
firms as well.
PROPOSITION 9. The set of possible two-step equilibria is the points

on the contract curve lying within the region of feasible two-
step schedules (i.e., those that induce the requisite differential

investment in y by the two groups). Each yi is above the opti-
mal level given the level of y for the other group.
Remark: This last property is not undesirable. If groups could

choose independently their own level of y given the level of the othe
group, they would (in the absence of collusion) ignore their con-
tribution to the other's productivity with detrimental results for
efficiency. The competitive market achieves the same effect as col-
lusion would.
It remains to consider one-step schedules. But there is little
new to be said. Depending upon the parameters of the model, there
may be a one-step schedule that dominates all the points on XY.
The equilibrium will then be a one-step schedule. It is also possible
that a one-step schedule dominates some but not all of the points
on XY. In that case the market has two possible types of equilib-
rium. This possibility did not arise in the separable case because
the set of possible two-step equilibria consisted of just one point.
Indeed, that is the principal difference between this case and the
previous one. As noted before, one-step equilibria are possible here
since firm specialization is ruled out by the complementary char-
acter of the inputs.
Two-step equilibria in the passive-response model correspond
to the shaded region in Figure IX. Thus, the effect of introducing
actively responding employers is to eliminate some of the less
efficient equilibria in the passive model. To be precise, it eliminates
all the Pareto inefficient equilibria and no more. The competitive
equilibrium will not generally maximize total net output. In gen-
eral, to achieve efficiency in the sense of maximum total net income
to individuals, it is necessary to allow wages to deviate from mar-
ginal products in such a way as to eliminate the signaling compo-
nent of the private return to the signal.15 In the competitive model
of either type, wages are bid up to marginal products, so that full
efficiency is inconsistent with competitive equilibrium except under
special circumstances.
It is interesting to reconsider the separable case using the pre-
ceding indifference curve argument. In the separable case the opti-
mal levels of Yi and Y2 are independent of each other. And the in-
difference curves are horizontal and vertical lines, respectively, for
groups 2 and 1. Let the optimal levels of y be y*1 and Y*2. They are
15. This is argued in Spence, "Competitive and Optimal Responses to
Signals: An Analysis of Efficiency and Distribution."
depicted in Figure X along with the constraints ensuring that in-

dividuals make the requisite choices of y. The shaded region is the
set of (Y1,Y2) that is feasible, that is to say, that causes each group
to select the appropriate yi. The point (Y*1,Y*2) may lie in this
region, in which case it is the unique equilibrium. If it does not
lie in this region, then the point A is the unique two-step equilib-
rium. This point will be established once it is shown that the lower
boundary of the feasible region has a minimum at y*1. For if it
does, then any movement away from A in the feasible region hurts
group 2 and either hurts group 1 or leaves them indifferent if the
movement is vertical upward.
Y2
y~~~~~~~~~~~y
Y. Y.
FIGURE X
The lower boundary of the feasible region is defined by

f (Yi) -c(y1) =f(Y2) -c1 (Y2),
from which it follows that
dy2 f' (Y1) -c'1 (y1 )
dy1 f2 (Y2) -c'1 (Y2)
Thus, dy2/dy1= 0, when f'i (Yj) =c'1 (Y), i.e., at y*1. Moreover, for
Yi<y*1, f'i-c'1>0 and conversely. And for Y2>Y*2, O>f'2(Y2)
-c2 (Y2) > f'2 (Y2) -c'l (Y2) because c'1 > c'2. The
the slope of the constraint is negative and con
Thus, the minimum occurs at y*1, and the previous argument es-
tablishes that A is the unique candidate for a two-step equilibrium.
Earlier remarks about one-step equilibria are still applicable
and need not be repeated.
Tests and Contingent Contracts
Implicit in the preceding analysis is the concept of an ideal
signal, one that has a zero cost for those who emit it, and a very large
(or perhaps infinite) cost for those who do not. When such signals
are available, they will be used in preference to others in the
active-response case, and they ensure that the equilibrium in the
signaling world duplicates that in the competitive world of perfect
information. Certain kinds of aptitude tests may approximate ideal
signals.
On the other hand, there are several reasons for expecting gen-
eralized potential signals, like education, to carry information. First,
they are productive as well as informative, and it is not easy for
employers to distinguish the effects. Second, because they are produc-
tive, they will be invested in anyway, so that they are available as
signals automatically. Third, because they are generalized signals
for many markets and jobs and because individuals may be uncertain
about the jobs they may ultimately want to have, the lowering or
dropping of an educational prerequisite by a single firm or industry
will not necessarily affect the signal choices of individuals. But if
that is true, then lowering a signaling prerequisite is not a competi-
tive strategy. It is, of course, necessary to assume that firms are
limited in size and range of markets in which they can operate. To
get around this problem, firms and industries would have to act
collectively. But there is little incentive for such collective action,
since in the end it benefits employees. The argument does, of course,
rest upon individual uncertainty about future preferences for vari-
ous kinds of jobs.
I have discussed active responses on the receiving side of the
market. Active responses are possible on the sending side as well.
The principal alternatives to costly signals are contingent contracts.16
The employee agrees to work for a certain salary now, and a fu-
ture salary contingent on the productivity he will be discovered to
have. Explicit contracts of this type are occasionally observed.
Moreover, they may be implicit and common in the salary struc-
16. See Salop and Salop, op. cit.
tures of business organizations. However, it is perhaps worth noting

some qualifications. Contingent contracts do two things. They can
put a time limit on the averaging of productivities over people. This
time limit affects the benefits of signaling. But this is not the inter-
esting point. The interesting point is that carefully structured con-
tracts can replace all costly signals by inducing individuals to
reveal their characteristics by their choice of contract. The quali-
fication, of course, is that individuals know their productivities on
particular jobs in advance. If they do not have this information,
they will not be able to reveal it in their contracting behavior.
Second, if the observation of individual capability within the firm is
costly, the signal may function in part as a permanent substitute
for this kind of observation, rather than as an interim replacement
for it. This information will be productive if nontrivial job allocation
decisions are based upon it. But even if it is not productive, indi-
viduals will invest in it by signaling because of the redistributive
effect. Nevertheless, contingent contracts are a potentially powerful
means of avoiding inefficient signals when individuals are informed
about their own capabilities on specific jobs. They therefore de-
serve further treatment at both the descriptive, empirical, and the
policy or prescriptive levels.
VIII. CONCLUDING REMARKS
I began by proposing to investigate the differences and similari-

ties between active and passive responses to signals in a competi-
tive market. The relevant general conclusions seem to be these.
From the set of equilibria in the passive model, the active
response causes the selection of the subset of Pareto undominated
equilibria. Equilibria that are Pareto-inferior to other equilibria in
the passive-response case are simply eliminated by the more sophis-
ticated and informed competitive behavior.
The net income-maximizing levels of the signal lie on the con-
tract curve (almost by definition) but may not be consistent with
individual choice of signals unless wages deviate from marginal
products. But the latter is inconsistent with competition.
When the production function is separable in the two groups, or
when there is limited complementarity, the Rothschild-Stiglitz prof-
erty holds. A situation in which both groups select the same level
of the signal is inconsistent with equilibrium and as a result, there
may be no equilibrium. This problem does not arise in the case of
highly complementary inputs, since firms will never rationally try

to specialize in hiring one group.
APPENDIX A: SUMMARY OF THE PASSIVE-RESPONSE MODEL
In terms of the notation used earlier, a passive-response model

equilibrium is reached when
W - Ci (YO) > Wk - C (Nk), if =k, ink =1,2,
and when
wt-=h(yi) i = i 2.
Alternatively, if both groups signal at the same level y" (a one-
step schedule), then the offered wage w" satisfies
wo1 = f (v")
The fundamental difference is that, in the passive-response case,
there is no tendency to move toward levels of yj that maximize
fi (y) - c, (yi). Thus, Figure II exhibits an equilibrium-wage-offer
schedule in the passive-response model, but not in the active-response
model discussed in this paper.
The major properties of the passive-response model are as fol-
lows:
1. There is typically a continuum of equilibria in which the

signal is informative.
2. The equilibria are orderable by the Pareto criterion.
3. Except in cases like that depicted in Figure IV, such equi-
libria are inefficient in that at least one group overinvests or
another underinvests in the signal.
4. In general, efficient investment in the signal is inconsistent
with having wages equal to expected marginal products
given the signal.
5. One-step wage-offer schedules with no information being
carried by the signal are always equilibria in addition to
the two-step schedules referred to above.
APPENDIX B: THE ELIMINATION OF DOMINATED, PASSIVE EQUILIBRIA
It is relatively easy to establish that a Pareto dominated equi-

librium in the passive-response case cannot be an equilibrium in
the active-response model. Suppose that there are a finite number
of types of people and a finite number of signals. Let fy= the pro-
ductivity of a person of type i with signal j. A partition of the types
of people r= (r,, . . ., J) is an allocation of groups to signals.

We define
:> fijqi
ierj
:> qia
ierP
for rj=,-. If wages equal expected productivities given the signals,

Wj= mj, j= 1, . . . , J. A partition r is called feasible if for all j and
all iErj
Wj-Cij> Wk-Cik
for all k7&j. A feasible partition r and the corresponding wage vec-
tor w are a passive-response equilibrium.
If there were two such equilibria (r',w') and (r2,w2) with the
property that for all i
max wj -cij> max wj2 - c,
j j
then (rJ2,w2) cannot be an active-response equilibrium. The reason
is that if all firms were offering w2 and then one of them switched to
WI- e for some small E, the firm that switched could hire all, or as
much, of the labor force as it wanted and make a profit. Therefore,
Pareto dominated passive-response equilibria are excluded.
We have not yet established that wages and expected produc-
tivities are equal in the active-response case. The argument is as
follows. First, the total wage bill must equal total output or
W= Ew1 > qi= : X fjjq,=M.
ierP ierF,
Otherwise, if W <M someone could raise all wages by E, not affect
the partition r, and therefore M, and hence make a profit. Now
suppose that wj < mj for some j. Then Wk> mk for some k=X=j. But
then any firm that lowered WR would get rid of this unprofitable
group without affecting other m1's, for all the people with signal k
would go to other firms. Hence the firm lowering wk would increase
profits. Therefore, Wk> Mk is impossible in an equilibrium. This
combined with W = M ensures that wages equal conditional ex-
pected productivities for all signals.
This fact (which defines passive-response equilibria) combined
with the analysis above ensures that active-response equilibria are
a subset of the Pareto undominated passive-response equilibria.
This argument, given for fixed productivities, carries over to sim-
ilar firms with diminishing marginal products to inputs. Each group
is allocated in equal numbers to each firm in an equilibrium.
HARVARD UNIVERSITY

Competition in Salaries, Credentials, and Signaling Prerequisites For Job (A J) 1976

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Competition in Salaries, Credentials, and Signaling Prerequisites for Jobs

Author(s): Michael Spence

I. Introduction, 51.-II. The choice of behavioral hypothesis, 53.-

In previous models of signaling in job markets, it has been as-

* This work was supported by National Science Foundation Grants GS-

suggested that this more sophisticated behavior by receivers of

1. M. Spence, Market Signaling: Information Transfer in Hiring in Re-

II. THE CHOICE OF BEHAVIORAL HYPOTHESIS

The active-response hypothesis has two informational under-

3. The insurance case with adverse selection is treated in great generality

hypotheses, based upon the types of complexity considerations dis-

f21 (Y) ?fl1 (Y) for all y.

f22 (Y) ?f12 (Y) -

4. Spence, op. cit.

productive in the low-skilled job than they are in the high-skilled

f21 (Y) > f22 (y) for y < y",

The quantity fj (y) will be referred to as the productivity of gro

IV. ANALYSIS OF EQUILIBRIA

The basic diagram is shown in Figure I. On it are plotted fi(y)

8. It is assumed that cd(y) is convex, i=1, 2.

PROPOSITION 1. If two groups signal differently, each will receive its

It is worth noting that we need consider only step functions

Figure III yj is shifted to the level at which fI(y) -cl(y) is max-

PROPOSITION 2. The lower productivity group will signal at the

ww, X *~~ ~ ~ ~Y)

A similar argument can sometimes be made for group 2, the

receives wages equal to productivity. In particular, it is to be noted

PROPOSITION 3. Efficient levels of investment in the signal and com-

We turn now to a case in which the snag occurs. In Figure Va

12. To complete the argument, we have to consider a competitor who

employer's ability to allocate high-productivity people to the more

PROPOSITION 4. The wage schedule shown in Figure Vb is the only

the two groups (and hence information being carried by the

I hasten to add that we have not yet shown the schedule in

efficient points, a one-step schedule would never be competitive be-

with a graph of f (y) superimposed on it. Because of the assumptions

will do. It is an interval because of the implicit assumption that the

PROPOSITION 5. Excluding the possibility that firms specialize by

However, if a one-step schedule is preferred by both groups, or

PROPOSITION 6. Excluding firm specialization in labor types, we see

To summarize the discussion thus far, we have three types of

the signal does not contribute to the productivity of individuals in

V. COMPARISON WITH THE PASSIVE-RESPONSE EQUILIBRIA

This preliminary categorization of equilibria invites compari-

VI. SPECIALIZED FIRMS

13. See Spence, "Competitive and Optimal Responses to Signals: An

tion is unlikely to be observed. It is not, however, logically impos-

14. This property is an instance of the general theorem of Rothschild

steeper than c2(y), the indifference curves of group 1 will always be

PROPOSITION 7. If firm specialization is consistent with the produc-

From Proposition 4 the only two-step schedule that is a candi-

PROPOSITION 8. If there is a one-step schedule preferred by both

This argument depends upon there being both separability and

VII. EQUILIBRIA WITH COMPLEMENTARY FACTORS

Firms are assumed to be identical for simplicity. Let q.z=the

difference curves for both groups. Points on an indifference curve

Also shown in Figure VIII are the tangencies of the in

Suppose that all firms were located at a point like A on the

PROPOSITION 9. The set of possible two-step equilibria is the points

step schedules (i.e., those that induce the requisite differential

Remark: This last property is not undesirable. If groups could

depicted in Figure X along with the constraints ensuring that in-

The lower boundary of the feasible region is defined by