Adverse selection and employment cycles

This article examines a dynamic adverse-selection model that generates equi librium employment cycles. In the model, firms hire workers from unemployme nt, observe workers' productivity through time, and (following the profit-m aximizing rule) eventually fire unproductive workers. If hiring costs are l ow, the dynamical system converges to a steady state in which the unemploym ent pool contains mostly low-ability workers. However, if hiring costs are sufficiently large, this "lemons effect" would make firms unwilling to hire workers. In this case, the system converges to a cyclical equilibrium in w hich firms alternate between hiring and not hiring.