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Signaling versus Auditing

We analyze a competitive labor market in which workers signal their productivities through education a la Spence (1973), and firms have the option of auditing to learn workers’ productivities. Audits are costly and non–contractible. We characterize the 
trade–offs between signaling by workers and costly auditing by firms. Auditing is always associated with (partial) pooling of worker types, and education is used as a signalonly if relatively few workers have low productivity. Our results feature new auditingpatterns and explain empirical observations in labor economics like wage differentialsand comparative statics of education choices. Our analysis applies also to other signalingproblems, e.g., the financial structure of firms, warranties, and initial public offerings.