Performance pay and adverse selection

Espen R. Moen and Åsa Rosén ()
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Åsa Rosén: Swedish Institute for Social Research, Stockholm University, Postal: SE-106 91 Stockholm, Sweden

No 2/2001, Working Paper Series from Swedish Institute for Social Research

Abstract: 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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Date: 2001-12-18
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Related works:
Working Paper: Performance Pay and Adverse Selection (2004)
Journal Article: Performance Pay and Adverse Selection (2005)
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