Performance pay and adverse selection
We study equilibrium wage contracts in a labour market with adverse selection and moral hazard. Firms offer incentive contracts to their employees to motivate them to exert effort. Providing incentives comes, however, at a cost, as it leads to misallocation of effort across tasks. With ex ante identical workers, the optimal wage contract is linear, and the equilibrium resource allocation optimal. With ex ante heterogenous workers, firms may increase the incentive power of the wage contract to attract the better workers. The resulting equilibrium is separating, in the sense that workers self-select on contracts. Furthermore, the contracts offered to the good workers are too high powered compared to the contracts that maximise welfare.
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- Holmstrom, Bengt & Milgrom, Paul, 1991. "Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design," Journal of Law, Economics and Organization, Oxford University Press, vol. 7(0), pages 24-52, Special I.
- Oliver Hart & Bengt Holmstrom, 1986. "The Theory of Contracts," Working papers 418, Massachusetts Institute of Technology (MIT), Department of Economics.