Screening Versus Sorting in a Principal-Agent Model with Moral Hazard and Adverse Selection

This paper proposes a principal-agent model of moral hazard and adverse selection that introduces the notion of screening, which is distinct from sorting; and distinguishes between ability that is privately known by the agent versus general ability that is observable by the principal and market. Sorting is the traditional process by which the adverse selection problem is resolved. Screening is the process we propose by which agents that are deemed to be unsuitable are rejected. Used in conjunction with sorting, we consider ex-ante screening on the basis of the (observable) measure of general ability; and ex-post screening on the basis of the private measure of ability. We identify the benefits and costs incurred by the principal associated with hiring an agent with superior ability, and derive the manner in which the compensation mechanism should be adjusted to take into account the roles of screening. The principal may prefer agents with inferior qualifications, rejecting those who are “overqualified”; conversely, she may select an agent with a distinguished pedigree, rejecting agents who are “underqualified”. Screening alters the relationship between the compensation mechanism and the characteristics of the agency relationship, causing established results to change, such as the negative link between risk and incentives. The empirical ramifications of screening are important: not controlling for screening introduces bias and inconsistency in estimation