Informal versus formal search: Which yields better pay?

• Published date: 01 September 2016
• Author: Semih Tumen
• Date: 01 September 2016
• DOI: http://doi.org/10.1111/ijet.12093

doi: 10.1111/ijet.12093

Informal versus formal search: Which yields better pay?

Semih Tumen∗

Estimates on the effect of job contact method (i.e., informal versus formal search) on wage offers

vary considerably across studies, with some finding a positive correlation between getting help

from informal connections and obtaining highly paid jobs, while others finding a negative one.

In this paper, I investigate theoretically the sources of discrepancies in these empirical results.

Using a formal job search framework, I derive an equilibrium wage distribution which reveals

that informal search yields for some groups higher and for some others lower wages than formal

search. The keyresult is the existence of non-monotonicities in wage offers. Twop otentialsources

of these non-monotonicities exist: peer effects and unobserved worker heterogeneity in terms of

the inherent cost of maintaining connections within a productive informal network. The model

predicts that a greater degree of unobserved heterogeneity tilts the estimates towardproducing a

positive correlation between informal search and higher wages, whereas strongerpeer influences

tend to yield a negative correlation. This conclusion informs the empirical research in the sense

that identification of the true correlation between job contact methods and wage offers requires

a careful assessment of the unobserved heterogeneity and peer influences in the relevant sample.

Key wor ds job search, informal network, peer effect, heterogeneity, non-monotonicity

JEL classification D85, J31, J64

Accepted 16 February 2015

1 Introduction

The rationale for the choice between using and not using informal job search channels is not well

understood in the literature.1Neither is it often well grounded why some groups relymore on these

social contacts than others, nor why the patterns of wages vary across these groups. The well-known

stylized fact that around a half of all new jobs are filled through social contacts in major developed

economies throws the endeavor to investigate the connections between the choice of job search

method and the associated labor market outcomes into sharp relief.2

∗Research and Monetary Policy Department, Central Bank of the Republic of Turkey, Ankara, Turkey. Email:

semih.tumen@tcmb.gov.tr

I thank Patrick Doreian, SteveDurlauf, Luca Flabbi, James Heckman, Brent Hickman, Ayse Imrohoroglu, Rafael Lopes de

Melo, WilliamNeilson, seminar participants at the University of Bern, University of Chicago, and the participants of the

2012 European Society for Population Economicsconference in Bern, and 2012 Econometric Society European Meeting

in Malaga for their useful suggestions. I am particularly grateful to Makoto Yano (the editor) and an anonymous referee

for very helpful comments. The views expressed here are of my own and do not necessarily reflect those of the Central

Bank of the Republic of Turkey. All errors are mine.

1Formal sources of job information are the publicly available hiring channels such as newspaper advertisements, employ-

ment agencies, union hiring services, and various other placement services. The informal sources include referrals from

relatives, friends, acquaintances, and direct/indirect contactsthrough social networks.

2See, for example, Rees (1966), Corcoran etal. (1980), Holzer (1988), Marsden and Campbell (1990), Granovetter (1995),

Bewley (1999), Addison and Portugal (2002), and Ioannides and Loury (2004).

International Journal of Economic Theory 12 (2016) 257–277 © IAET 257

International Journal of Economic Theory

Informal versus formal search Semih Tumen

In this paper, I ask whether informal search methods generate higher or lower wage offers than

formal search. There is a divide in the empirical literature, with some studies finding a positive

correlation between getting help from informal connections and obtaining highly paid jobs, and

others finding a negative one.3I attempt to put together a coherent theoretical story that can shed

some light on this puzzle. My purpose is to construct a theoretical model, using which one can

practically disentangle the forces governing the correlation between job contact methods and wage

outcomes. Such a framework will inform the empirical research about the potential avenuesthat can

be followed in reconciling the contradictory findings reported in the existing literature.

Using a discrete choice model of job search with worker heterogeneity and segmented markets,

I derive an equilibrium wage distribution which demonstrates that jobs found through informal

methods pay for some groups higher and for others lower wages than jobs found through formal

methods.4The key is the existence of non-monotonicities in wage offers. The main choice for the

unemployed job searcher is to decide whether to search informally and/or formally. Those who

choose to search via formal methods only receive a certain equilibrium wage. The wages of those

who choose to call their informal connections may be lower or higher than the wage offer generated

through formal search. In particular, I show that, at the equilibrium, a certain proportion (say,

L∈[0,1]) of informal searchers accept lower wages than the formal methods can generate and the

rest (say, H=1−L∈[0,1]) accepthig her wages. The main theoreticalinsig ht of the paper is that

the relative sizes of Land Hare determined by two factors: unobserved heterogeneity in the cost of

informal search and the degree of peer effects in the relevant population.

The first prediction of the model is that a greater degree of unobserved heterogeneity in the cost

of informal search increases the likelihood of a positive correlation between using informal search

and earning high wages. This suggests that as the proportion of better-connected workers increases

in the population, informal search will be more likely to yield higher wages. Failing to control for

this unobserved heterogeneity element may lead to contradictory estimates depending on which

part of the population the sample represents. For example, in a breakthrough paper in the literature,

Marmaros and Sacerdote (2002) document a positivecorrelation between earnings and the tendency

to use informal contacts; but their sample consists of Dartmouth College seniors, who are potentially

much better connected than a sample representingthe whole population in the United States. Simon

and Warner (1992) also document a positive correlation using a sample of individuals from the

1972 Survey of Natural and Social Scientists and Engineers. This sample also potentially suffers from

the same problem. Similarly, Rosenbaum et al. (1999) find that the correlation between earnings

and getting help from “close relatives” tends to be positive for men aged 19–28 years. This is again

plagued with a similar problem, because one becomes better connected as his/her close relatives(i.e.,

cousins, brothers, sisters) grow older and become better connected. Similar arguments also hold

for the papers reporting a negative correlation. For example, Elliot (1999) documents that workers

residing in some certain neighborhoods, who find jobs through non-white contacts, tend to receive

low wage offers. Similarly, Beggs and Hurlbert (1997), Mencken and Winfield (2000), and Smith

3See Ioannides and Loury (2004) for an extensive review of the related literature.

4Workers differ in terms of the inherent cost of maintaining connections with a productive informal network. Using

formal methods in job search is costless for all workers,whereas the cost of staying connected with an informal network is

distributed around zero. Inother words, some groups have inherent a priori advantages that provide incentives to invoke

informal contacts, while others have disadvantages and are drivento rely on formal methods only. The following insight

from Calvo-Armengol and Jackson(2004) motivates the source of worker heterogeneity: if there are costs associated with

remaining in a network, those who have lower costs will be more willing to stay connected.T he sourcesof these costs

include skill maintenance, education, and various opportunity costs. Similar references to cost heterogeneity are also

provided in various studies, including Holzer (1988) and Mortensen and Vishwanath(1994).

258 International Journal of Economic Theory 12 (2016) 257–277 © IAET