Search, Matching, and Signaling : Do Markets Help Relationships?

How do market opportunities influence the formation and development of long-term relationships? To answer this question, I build a model of employment relationships where the worker has private information about match quality, the firm learns about match quality over time, and the firm makes a match-specific investment. Improved market opportunities for workers promote productive relationships because they let the worker signal her firm-specific productivity by forgoing market opportunities. Signaling allows the firm to bypass the learning stage and encourages investment (signaling effect). Improved market opportunities for firms, however, discourage long-term relationships and undermine investment incentives (layoffs effect). I embed the relationship game in a search market equilibrium where market opportunities for both parties depend on search frictions and market thickness. With intermediate values of market thickness, relationship productivity and worker welfare are u-shaped in search frictions: when search frictions decrease from high to intermediate levels, the layoffs effect dominates; when search frictions are sufficiently low, the signaling effect dominates