Layoffs, Lemons and Temps∗

We develop a dynamic equilibrium model of labor demand with adverse selection. Firms learn the quality of newly hired workers after a period of employment. Adverse selection makes it costly to hire new workers and to release productive workers. As a result, firms hoard labor and under-react to labor demand shocks. The adverse selection problem also creates a market for temporary workers. In equilibrium, firms hire a buffer stock of permanent workers and respond to changing business conditions by varying their temp workers. A hiring subsidy or tax can improve welfare by discouraging firms from hoarding too many productive workers. We extend the model to analyze dynamic variation in adverse selection in response to aggregate shocks. In the model with aggregate dynamics, the adverse selection problem causes labor demand to under-react to shocks relative to a frictionless benchmark. While the aggregate shocks in the model are temporary, the equilibrium change in temp employment is permanent. JEL Codes: D82, E24, J23