Equilibrium Incentive Contracts

Espen R. Moen and Asa Rosen

No 3790, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We study a labour market in which firms can observe workers’ output but not their effort, and in which a worker’s productivity in a given firm depends on a worker-firm specific component, unobservable for the firm. Firms offer wage contracts that optimally trade off effort and wage costs. As a result, employed workers enjoy rents, which in turn create unemployment. We show that the socially efficient incentive power of the equilibrium wage contract is constrained in the absence of unemployment benefits. We then apply the model to explain the recent increase in performance-pay contracts. Within our model, this can be explained by three different factors: (i) increased importance of non-observable effort, (ii) a fall in the marginal tax rate, (iii) a reduction in the heterogeneity of workers performing the same task. The likely effect of all three factors is an increase in the equilibrium unemployment rate.

Keywords: contracts; efficiency; incentives; unemployment (search for similar items in EconPapers)
JEL-codes: E24 J30 J41 (search for similar items in EconPapers)
Date: 2003-02
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