Separating Equilibrium And Persistent Inefficiency

In context of the traditional Spence signaling model, the realization of a separating equilibrium ensures that each worker is allocated to the sector of the economy where they are most productive. Traditional analysis assumes, however, that the incremental returns to labor employment are constant across workers of any given type. This paper demonstrates that the efficiency properties of separating equilibria can be profoundly altered by the presence of nonlinear returns. In particular, we show that separating equilibria fail productive efficiency whenever production satisfies a weak form of diminishing returns. This separating equilibrium efficiency failure persists whether or not equilibrium wages are assumed to depend solely on distributions of worker productivity.