Promotions, Adverse Selection, and Efficiency

Abstract

This paper considers how adverse selection in the labor market affects the efficiency of promotion decisions. In the model, when a high ability worker is not promoted 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. In the presence of asymmetric employer learning, adverse selection can stop this type of turnover from occurring due to the private information of the worker’s current employer. We show that employing up-or-out contracts for young workers with the highest expected ability can be an efficient response to this adverse selection problem, because it forces turnover for workers not promoted which improves the efficiency of promotion decisions. In addition, our analysis explains several observations concerning real-world promotion decisions and practices related to up-or-out, including circumstances in which up-or-out is typically employed, the existence of dual career-track employment systems, and the pairing of up-or-out with outplacement services in professional service labor markets.