You own a company that produces chairs, and you are thinking about hiring one more employee. Each chair produced gives you revenue of $10. There are two potential employees, Fred Ast and Sylvia Low. Fred is a fast worker who produces ten chairs per day, creating revenue for you of $100. Fred knows that he is fast and so will work for you only if you pay him more than $80 per day. Sylvia is a slow worker who produces only five chairs per day, creating revenue for you of $50. Sylvia knows that she is slow and so will work for you if you pay her more than $40 per day. Although Sylvia knows she is slow and Fred knows he is fast, you do not know who is fast and who is slow. So this is a situation of adverse selection.
a. Since you do not know which type of worker you will get, you think about what the expected value of your revenue will be if you hire one of the two. What is that expected value?
b. Suppose you offered to pay a daily wage equal to the expected revenue you calculated in part a. Whom would you be able to hire: Fred, or Sylvia, or both, or neither?
c. If you know whether a worker is fast or slow, which one would you prefer to hire and why? Can you devise a compensation scheme to guarantee that you employ only the type of worker you prefer?