Referral Hiring and Wage Formation in a Market with Adverse Selection

The widespread use of employee referrals raises questions regarding how they affect labor market outcomes: Does referral hiring lead to a more efficient allocation of workers compared to when hiring is possible only on a competitive market? To utilize the social links of their current employees, are employers willing to pay a wage premium? We present a game-theoretic model and provide results from a laboratory experiment to address these questions. In line with the theoretical predictions, employers often hire via employee referrals, which in turn mitigates adverse selection and elevates wages. Importantly, employers anticipate the future value of incumbent high-productivity employees' social links and are willing to take the risk of offering higher wages, even when hiring on the competitive market. We also find that employers' risk aversion and the dynamic nature of the hiring process can help account for the inefficiency remaining in the labor market