Market Signaling, Quality Control, and Rent Extraction: A Theoretical Model for Licensing in Occupations

Abstract

This paper aims to model the formation of occupations through licensing. In particular, I examine pure strategy Nash equilibria in a three-stage game, played by a monopoly licenser and n individuals with heterogenous ability. The licenser publicizes a fee structure for the license, the individuals choose whether or not to obtain the license, and determine output simultaneously. By combining aspects from both patent licensing and market signaling, our model shows that when 1. the demand is sufficiently high and 2. when the cost of obtaining the license is sufficiently large, there exist a unique equilibrium such that for a threshold ability, all individuals with higher ability obtain the license, and all individuals with lower ability do not. This shows that even when a license does not affect the productivity of individuals, it can still serve as a signal to select individuals that are good at their job. This model further shows that, contrary to past literature, a fixed fee scheme generates higher revenue for the licenser than an auction scheme. The results of this model have implications on the validity of a licenser’s control over barrier to entry, as well as how occupations may appear or disappear as the cost of a license changes.