Labor market flexibility and investment in human capital∗

Employers use signals of productivity to hire from a pool of workers. Educational systems produce these signals mostly by testing. Because educational tests may change the incentives to acquire different types of human capital, the link between achievement and productivity may be ambiguous. The tests may adversely affect the accumulation of useful but hard to test skills. Certain types of skills, such as creativity and ability to collaborate with others, are more costly to test than others, such as subject knowledge. Given this asymmetry, signals from the educational system are likely to lead individuals to trade off acquisition of “creativity ” for “knowledge”. Transparent labor markets that allow employers to signal the rewards to less testable skills induce an efficient allocation of investment in human capital. Less transparent markets encourage credentialism, testing, and rote memorization that characterize the educational system in many developing countries. We build a simple model of testing and human capital accumulation to show how rational agents may distort their accumulation of human capital in response to rewards in the labor market for knowledge and creativity. We show that individuals in rigid labor markets will favo