Labor Market Information Acquisition and Downsizing

Abstract

We study the optimal mechanism for downsizing the public sector which takes into account different informational constraints (complete versus asymmetric information on each worker’s efficiency) and political constraints (mandatory versus voluntary downsizing). Under complete information, the optimal structure of downsizing (who is laid-off and who is not) does not depend on the political constraint and is determined by the (marginal) cost of retaining a worker in the public sector. Since this cost includes his opportunity cost in the private sector, information acquisition on opportunity costs affects the structure of downsizing. Under asymmetric information, the political constraints determine which workers obtain information rents and therefore affect the structure of downsizing. An increase in the precision of the information on workers’ opportunity costs may increase or decrease social welfare depending on its impacts on the information rents.

Public sector downsizing is an increasingly important element in economic reforms of developing countries and transition economies.¹ Countries which followed state-led development strategies often exhibit bloated bureaucracy with overstaffed public enterprises. Severe labor redundancies in the public sector are common in transition economies, where the shift to a market economy requires a great number of workers to be relocated out of the public sector. In some other countries, the need for public sector downsizing comes from a fiscal crisis which requires a severe cutback in government expenditures.

While the gains from downsizing are potentially large, the chances of mishandling it are considerable as well. According to some recent cross-country studies of downsizing programs, adverse selection plagues downsizing programs so that many programs exhibit the “revolving door” syndrome, whereby separated workers are subsequently rehired,² and downsizing programs carried by governments before privatization tend to reduce instead of increasing privatization prices (Chong and López-de-Silanes, 2002). They also argue that a naïve mechanism using severance pay to induce voluntary separation is likely to fail in this respect since, when more able workers have better job opportunities in the private sector, such a mechanism induces good workers to leave and hence creates the subsequent need to rehire them.

The previous findings suggest that to be successful, a downsizing mechanism must carefully deal with adverse selection problems. For this purpose, we adopt a mechanism design approach and study the optimal mechanism for public sector downsizing which accounts for different informational and political constraints. Concerning informational constraints, we distinguish two kinds of information: one is about each worker’s productive efficiency in the public sector and the other is about each worker’s outside opportunity (i.e., the utility that he is expected to obtain in the private sector). Both kinds of information are necessary to determine the desirable size of downsizing and to successfully implement it.

Even if the government designs a mechanism properly accounting for the relevant informational constraint, the mechanism cannot be implemented if it is politically unfeasible.³ In this respect, we can distinguish two main forms of downsizing: mandatory and voluntary downsizing.⁴ Under mandatory downsizing, the government has the right to lay off any worker in the public sector and hence the political constraint is minimal. In contrast, under voluntary downsizing, any worker has the right to stay in the public sector with his current status and cannot be laid off against his will, and therefore the political constraint is maximal. In this paper, we consider these two extreme modes of downsizing although our analysis can be extended to an intermediate political constraint in which the government needs the approval of a majority of workers.

Download full text article here