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Uncertainty, Pay for Performance and Adverse Selection in a Competitive Labor Market

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  • Felipe Balmaceda

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Abstract

This paper develops a new rationale for the emergence of pay-for-performance contracts. The labor market is competitive, workers are risk averse and firms risk neutral. The paper shows that in stable environments more productive workers self-select into pay-for-performance jobs because risk is less costly to them than to their less productive counterparts which prefer fixed-salary contracts. When uncertainty is sufficiently large a pooling equilibrium emerges in which all workers have pay-for-performance contracts, thereby reducing more productive workers’ costs of being pooled with less productive workers. The model explains several empirical regularities unaccounted for by alternative models, such as markets where all observed contracts involve pay-for-performance, and also that such markets are more likely to emerge in highly uncertain environments.

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Bibliographic Info

Paper provided by Centro de Economía Aplicada, Universidad de Chile in its series Documentos de Trabajo with number 196.

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Date of creation: 2004
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Handle: RePEc:edj:ceauch:196

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  1. Daniel Parent, 2009. "The effect of pay-for-performance contracts on wages," Empirical Economics, Springer, vol. 36(2), pages 269-295, May.
  2. Canice Prendergast, 1999. "The Provision of Incentives in Firms," Journal of Economic Literature, American Economic Association, vol. 37(1), pages 7-63, March.
  3. Cho, In-Koo & Kreps, David M, 1987. "Signaling Games and Stable Equilibria," The Quarterly Journal of Economics, MIT Press, vol. 102(2), pages 179-221, May.
  4. Rothschild, Michael & Stiglitz, Joseph E, 1976. "Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information," The Quarterly Journal of Economics, MIT Press, vol. 90(4), pages 630-49, November.
  5. Mark Rosenzweig & Andrew D. Foster, . "Comparative Advantage, Information and the Allocation of Workers to Tasks: Evidence from an Agricultural Labor Market," Home Pages _066, University of Pennsylvania.
  6. Hellwig,Martin, 1986. "Some recent developments in the theory of competition in markets with adverse selection," Discussion Paper Serie A 82, University of Bonn, Germany.
  7. Bengt Holmstrom & Paul R. Milgrom, 1985. "Aggregation and Linearity in the Provision of Intertemporal Incentives," Cowles Foundation Discussion Papers 742, Cowles Foundation for Research in Economics, Yale University.
  8. Charles Brown, 1990. "Firms' choice of method of pay," Industrial and Labor Relations Review, ILR Review, Cornell University, ILR School, vol. 43(3), pages 165-182, February.
  9. Rosenthal, Robert W & Weiss, Andrew, 1984. "Mixed-Strategy Equilibrium in a Market with Asymmetric Information," Review of Economic Studies, Wiley Blackwell, vol. 51(2), pages 333-42, April.
  10. Matutes, Carmen & Regibeau, Pierre & Rockett, Katharine, 1994. "Compensation Schemes and Labor Market Competition: Piece Rate versus Wage Rate," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 3(2), pages 325-53, Summer.
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  12. Francine Lafontaine & Margaret E. Slade, 1998. "Incentive Contracting and the Franchise Decision," NBER Working Papers 6544, National Bureau of Economic Research, Inc.
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  16. Murphy, Kevin J., 1999. "Executive compensation," Handbook of Labor Economics, in: O. Ashenfelter & D. Card (ed.), Handbook of Labor Economics, edition 1, volume 3, chapter 38, pages 2485-2563 Elsevier.
  17. Mailath George J. & Okuno-Fujiwara Masahiro & Postlewaite Andrew, 1993. "Belief-Based Refinements in Signalling Games," Journal of Economic Theory, Elsevier, vol. 60(2), pages 241-276, August.
  18. Petersen, Trond, 1991. "Reward Systems and the Distribution of Wages," Journal of Law, Economics and Organization, Oxford University Press, vol. 7(0), pages 130-58, Special I.
  19. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
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Cited by:
  1. Bannier, Christina E. & Feess, Eberhard, 2010. "When high-powered incentive contracts reduce performance: choking under pressure as a screening device," Frankfurt School - Working Paper Series 135, Frankfurt School of Finance and Management.

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