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Layoffs as Part of an Optimal Incentive Mix: Theory and Evidence

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  • Anders Frederiksen

    () (Stanford University)

  • Elõd Takáts

    () (Princeton University)

Abstract

Firms offer highly complex contracts to their employees. These contracts contain a mix of various incentives, such as fixed wages, bonuses, promise of promotion, and threat of firing. This paper aims at explaining the reason why this incentive- mix arises. In particular, the model focuses on why firms are combining promotions and bonuses with firing. The theoretical model proposed is a job-assignment model with heterogeneous employees. In this model the firm is concerned about job assignment, because the overall productivity of the firm depends upon the quality of the employees and their allocation to jobs. The model shows that firing has a dual role. Firing creates incentives for the employees, and it is used as a sorting device that allows the firm to improve workforce quality. Thus, quality-concerned firms might want to combine cost-efficient incentives such as promotions and bonuses with firing. To comply with the Gibbons and Waldman critique, a large set of the model’s broader predictions is stated explicitly and tested on the personnel records from a large pharmaceutical company. The model’s predictions are shown to be consistent with the data.

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Bibliographic Info

Paper provided by Magyar Nemzeti Bank (the central bank of Hungary) in its series MNB Working Papers with number 2006/2.

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Length: 39 pages
Date of creation: 2006
Date of revision:
Handle: RePEc:mnb:wpaper:2006/2

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Keywords: personnel economics; incentive mix; layoffs.;

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  1. Baker, George & Gibbs, Michael & Holmstrom, Bengt, 1994. "The Wage Policy of a Firm," The Quarterly Journal of Economics, MIT Press, vol. 109(4), pages 921-55, November.
  2. Lazear, Edward P & Rosen, Sherwin, 1981. "Rank-Order Tournaments as Optimum Labor Contracts," Journal of Political Economy, University of Chicago Press, vol. 89(5), pages 841-64, October.
  3. Guasch, J Luis & Weiss, Andrew, 1980. "Wages as Sorting Mechanisms in Competitive Markets with Asymmetric Information: A Theory of Testing," Review of Economic Studies, Wiley Blackwell, vol. 47(4), pages 653-64, July.
  4. Farber, Henry S & Gibbons, Robert, 1996. "Learning and Wage Dynamics," The Quarterly Journal of Economics, MIT Press, vol. 111(4), pages 1007-47, November.
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  7. Baker, George & Gibbons, Robert & Murphy, Kevin J, 1994. "Subjective Performance Measures in Optimal Incentive Contracts," The Quarterly Journal of Economics, MIT Press, vol. 109(4), pages 1125-56, November.
  8. Medoff, James L & Abraham, Katharine G, 1980. "Experience, Performance, and Earnings," The Quarterly Journal of Economics, MIT Press, vol. 95(4), pages 703-36, December.
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  11. Gibbons, Robert & Waldman, Michael, 1999. "Careers in organizations: Theory and evidence," Handbook of Labor Economics, in: O. Ashenfelter & D. Card (ed.), Handbook of Labor Economics, edition 1, volume 3, chapter 36, pages 2373-2437 Elsevier.
  12. Lazear, Edward P, 1989. "Pay Equality and Industrial Politics," Journal of Political Economy, University of Chicago Press, vol. 97(3), pages 561-80, June.
  13. Bentley MacLeod, 2001. "Optimal Contracting with Subjective Evaluation," Theory workshop papers 357966000000000036, UCLA Department of Economics.
  14. James A. Mirrlees, 1976. "The Optimal Structure of Incentives and Authority Within an Organization," Bell Journal of Economics, The RAND Corporation, vol. 7(1), pages 105-131, Spring.
  15. Shapiro, Carl & Stiglitz, Joseph E, 1984. "Equilibrium Unemployment as a Worker Discipline Device," American Economic Review, American Economic Association, vol. 74(3), pages 433-44, June.
  16. Calvo, Guillermo A & Wellisz, Stanislaw, 1979. "Hierarchy, Ability, and Income Distribution," Journal of Political Economy, University of Chicago Press, vol. 87(5), pages 991-1010, October.
  17. Gibbs, Michael, 1995. "Incentive compensation in a corporate hierarchy," Journal of Accounting and Economics, Elsevier, vol. 19(2-3), pages 247-277, April.
  18. W. Bentley MacLeod & Daniel Parent, 1998. "Job Characteristics and the Form of Compensation," CIRANO Working Papers 98s-08, CIRANO.
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Cited by:
  1. Frederiksen, Anders & Ibsen, Rikke & Rosholm, Michael & Westergård-Nielsen, Niels C., 2006. "Labour Market Signalling and Unemployment Duration: An Empirical Analysis Using Employer-Employee Data," IZA Discussion Papers 2132, Institute for the Study of Labor (IZA).
  2. Anders Frederiksen & Odile Poulsen, 2006. "Rising Wage Inequality: Does the Return to Management Tell the Whole Story?," Discussion Papers 05-007, Stanford Institute for Economic Policy Research.
  3. Frederiksen, Anders, 2008. "Gender differences in job separation rates and employment stability: New evidence from employer-employee data," Labour Economics, Elsevier, vol. 15(5), pages 915-937, October.

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