Compensation Methods in a Competitive Labor Market: the Role of Asymmetric Information

In this paper we develop an asymmetric information model that provides a rationale for the existence of pay-for-performance contracts in the absence of incentive for effort and explains when and in which occupations pay-for-performance is more likely to be observed. In our model competition among firms for the best workers forces firm to link pay to performance in order to provide the best workers with a higher expected compensation. Furthermore, the model predicts among other things and contrary to the moral hazard model, that there is an equilibrium in which workers under contracts with a larger pay-for-performance sensitivity exert less effort than workers under contracts with a smaller pay-for-performance sensitivity. The paper also makes contributions to the theoretical literature on screening games. It is shown that in a competitive market and under a slightly modified timing than the one proposed by Rothschild and Stiglitz’ (1976) a unique equilibrium exits when a appropriately chosen equilibrium refinement is used and that the standard result in screening games in monopolistic settings known as no distortion at the top (see, Laffont and Tirole, 1996) does not hold in a competitive market.