Probation periods: How I see it at the moment

In net terms I am AGAINST the probation policy being put through today. That puts me in a pretty significant minority among my economics peers, oww well it gives us something to talk about. However, I would also add that I am NOT THAT against it – I am only against it in net terms because of value judgments.

In the comments on this post I stated:

When people make a contract they are agreeing (to set) down things that they are willing to accept given bargaining power etc – but ultimately they will only accept a contract when it makes them better off.

Now if the employer really values the probation period and the employee doesn’t care it should be allowed to happen – and it can in current law. If the employer doesn’t care and the employee does, the employee will take a lower wage to avoid it – all good, and as long as the firm is over the size of 20 employees the new law is cool with that.

However, there is a signaling issue because of a market imperfection – asymmetric information. In this case, the existence of a pure probation option leads to “too many” people getting stuck in these types of contracts, compared to the socially optimal level.

As a result, legislation to decrease the usefulness of probation periods could be socially optimal – however, the magnitude of these costs is the debatable issue.

Fundamentally the signaling issue is that the firm will assume people who do not want a probationary period are “bad employees”, even if in actuality they are just really don’t like the probation period! As a result, some employment relationships will end up with a probationary period, even if both the firm and employee don’t want it! This implies that the use of probation periods will be GREATER than the socially optimal level. Current costs surround the use of such contracts reduced the use of such a clause – which could have increased social welfare.

Given the prevalence of small firms in New Zealand, and the sensitivity of a “signaling equilibrium” to small shocks, a small change in labour law could lead to a significant increase in the number of contracts with probation periods. With my value judgment that the current number of probation contracts used is close to optimal (this is something we can debate 🙂 ) any law that increases the number significantly is no good.

Discuss 🙂

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  • What is the cost of having ‘too many’ probationary contracts? Do you think that firms will use them as a way to employ people short term where a fixed-term contract would be illegal? That’s certainly what I’d be worried about, absent of any actual knowledge 😛

    Putting that concern aside, you suggest that a signalling model would be appropriate for analysing this situation. As such, the ‘good’ employees would actually be in favour of probation periods if they were a credible signal. So wouldn’t reducing the barriers to making the signal actually improve market efficiency (presuming that it doesn’t increase the ease with which the signal can be faked)?

    I suppose what I’m asking is really what you’ve invited by your post: what makes you think that barriers to efficient signalling are producing an optimal outcome?

  • “I suppose what I’m asking is really what you’ve invited by your post: what makes you think that barriers to efficient signaling are producing an optimal outcome?”

    Very good question.

    It is because I think that there are “(heterogeneous) costs” to being on a probationary contract (Update as in multiple two different types of agents who associate different costs with the uncertainty of a probation period) for the employee. The optimal outcome would see them incorporate a probation period only if the benefit exceeded the cost.

    However, when probation contracts become popular, the firm may associate some signaling value on them – assuming that people who do not want a signaling contract are lazy employees.

    As a result, you could end up with contracts where probation is put into the contract even though the benefit to the employer is less than the cost to the employee.

  • “Do you think that firms will use them as a way to employ people short term where a fixed-term contract would be illegal? That’s certainly what I’d be worried about”

    I don’t know – I mean, it depends how “unskilled” work is in New Zealand. If we assume that their is an investment cost from “building” a worker, I am not sure that firms will be keen to dump workers every 89 days.

    Furthermore, if the firm only wants to hire a worker for 89 days, and the worker is happy with the rate of compensation, what is the problem?

  • To be more clear, I think there are four types of agents from a mix of characteristics:

    Lazy to Hard working and,

    Averse to probation to not averse.

    As firms can’t observe the characteristics, they may presume that agents who don’t want a probation period are lazy – when in fact some of them are just averse to probation. In this sense, people who are hard working by averse to probation have to choose between taking a contract with probation or not at all, even though net welfare would be maximised if no probation clause existed.

    In the extreme, we can compare a situation where everyone is on probation to a situation where no-one is. I don’t think it is clear which situation is socially optimal.

    Because of signaling, it is possible that allowing probation could lead to an equilibrium where everyone has to accept probation in their contract, even though with full information the employer and employee would not agree on a contract with probation.

    As a result, if the benefit to employees is sufficient small and the cost to employees in the right range, it could be socially optimal to ban probation altogether.

  • “if the firm only wants to hire a worker for 89 days, and the worker is happy with the rate of compensation, what is the problem?”

    It’s illegal to hire someone on a fixed term contract if you don’t have a good reason for the fixed term. I can imagine that there are benefits to having people on rolling probationary contracts since it gives you a lot more flexibility in dealing with your workforce. That probably has to be balanced against the specific investment you’ve made in the worker, as you point out.

    “Averse to probation to not averse.”

    The question is, why are they averse to probation? Why would hard working types not want to credibly signal their hard working nature? Admittedly, there is probably uncertainty over whether they keep the job, regardless of their effort. But that’s an issue that can be sorted out with the right contractual incentives.

    I think we really need an endogenous explanation of why they don’t like the probationary period in order to make this model fly. I’m not panning your model, I just think it needs further development before you publish it in the AER 😉

  • “I can imagine that there are benefits to having people on rolling probationary contracts since it gives you a lot more flexibility in dealing with your workforce”

    In the law they are passing it is illegal to have a rolling probation contract – you can’t hire the same person with a probation clause twice in some space of time.

    “I thin we really need an endogenous explanation of why they dont’ like the probationary period in order to make this model fly”

    Agreed – I am just assuming that “preferences differ” – which is of course a cardinal sin in economics. However, for practical purposes its just how I feel on the inside when looking at this policy ya know 😛

  • CPW

    Matt, it seems I could easily reverse your example, and say we’re currently stuck in an ineffecient equilibrium where employers want to use probation periods but are afraid that would signal that they’re bad employers who are prone to firing.

    I realize that assessment of this policy hinges on a number of aspects for which their is no quantitative data yet, but my instinct is that workers hiding their type (hard-worker or shirker) is a bigger inefficiency than employers hiding their type (good or bad employer). I base this on the fact that the returns to securing a good job through hiding your quality seem a lot higher than the gains from constantly firing and rehiring (given that new workers normally cost the firm in net terms).

  • “Matt, it seems I could easily reverse your example, and say we’re currently stuck in an ineffecient equilibrium where employers want to use probation periods but are afraid that would signal that they’re bad employers who are prone to firing.”

    Yes, definitely.

    “I realize that assessment of this policy hinges on a number of aspects for which their is no quantitative data yet, but my instinct is that workers hiding their type (hard-worker or shirker) is a bigger inefficiency than employers hiding their type (good or bad employer)”

    Agreed – however, my comparison many depends on employees with multiple dimension that depend on the existence of probation – rather than an employee and employer dimension. I definitely do not assume bad employers.

    As Rauparaha says my idea needs a lot of work – however, I do get the feeling that we can have “excess probation, a feeling I just can’t shake. As a result, at some point I must model it 😛

  • The so-called ‘probationary period’ is current law is really quite different to the National proposal because the employer still has to follow quite strict rules about process. The employment court will rule in favour of the employee whenever it can, e.g. if the employer makes any kind of procedural error in the dismissal process. It is really quite tricky for employers to get rid of anyone in a way that the employment court will find acceptable.

    This does away with all of that, but only for the first 90 days. That is the principal advantage.

  • CPW

    Matt, I don’t doubt you can model a situation where compulsory probation is bad compared to “perfect information, negotiable probation”, but I really think the question here is whether it is bad compared to “imperfect information, no probation”, which on the basis of Nigel’s comment, is the status quo.

  • “This does away with all of that, but only for the first 90 days. That is the principal advantage.”

    Indeed, but by increasing its effectiveness you also increase the use of the policy, and its ability as a signaling device – which is where I think there is the potential for movement to a suboptimal outcome.

    “Matt, I don’t doubt you can model a situation where compulsory probation is bad compared to “perfect information, negotiable probation”, but I really think the question here is whether it is bad compared to “imperfect information, no probation”, which on the basis of Nigel’s comment, is the status quo.”

    Indeed I completely agree. However, as I have said it is not obvious which one of these outcomes is better – it depends on what one is further away from the 1st best outcome. Remember, we are in a second best world here 😉

  • “Remember, we are in a second best world here ”

    Huh??? I never expected a Catholic to acknowledge constraints on God’s creative powers 😛

  • I’m not sure if Catholicism ensures first best solutions – I should research that and add it to this post:

    http://tvhe.wordpress.com/2007/10/31/was-jesus-an-early-applied-economist/