STRATEGY AND BUSINESS ECONOMICS


Promotions, Adverse Selection, and Efficiency


MICHAEL WALDMAN


CHARLES H. DYSON PROFESSOR OF MANAGEMENT Samuel Curtis Johnson Graduate School of Management


Cornell SC Johnson College of Business Cornell University


Journal of Labor Economics, 43, 1, January 2025 LINK TO PAPER


Co-authors • Michael Waldman


Charles H. Dyson Professor of Management, Samuel Curtis


Johnson Graduate School of Management, Cornell SC Johnson College of Business, Cornell University


• Zhenda Yin, Shanghai Jiao Tong University and Peking University


Summary Up-or-out contracts are prevalent in professional service labor markets (con-


sulting, accounting, law, etc.), where they are most commonly found in the employment of young workers with the highest expected ability. Why is that? Tis paper provides an answer to that question by building on the approach to turnover in labor markets pioneered in Greenwald (1986), in which current employers learn more about worker ability than prospective employers. Te basic argument is that adverse selection in labor markets stops the efficient movement of high-ability workers to the firms and jobs that value ability the most. In turn, up-or-out contracts can emerge in equilibrium for young work- ers with the highest expected ability as an efficient response to this adverse selection problem.


We consider how adverse selection affects the efficiency of turnover and postturnover job assignments. In the model, when a high-ability worker is not promoted at the worker’s current employer because of a lack of available managerial openings, it is efficient for the worker to move to a firm seeking a high-ability worker to promote. But this type of turnover does not occur given asymmetric information and adverse selection. Te authors show that up-or- out contracts can be an efficient response to this inefficiency, where their anal- ysis matches several observations concerning real-world promotion decisions and practices related to up-or-out.


CONTENTS | RESEARCH WITH IMPACT: CORNELL SC JOHNSON COLLEGE OF BUSINESS • 2025 EDITION TO MAIN


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