On Employment Contracts with Heterogeneous Workers and Endogenous On-the-job Search

Francis Kiraly
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Francis Kiraly: Department of Economics Keele University,, Postal: Keele, Staffordshire, ST5 5BG, UK

No KERP 2003/04, Keele Economics Research Papers from Centre for Economic Research, Keele University

Abstract: This paper considers an equilibrium search model with on-the-job search where firms set wages.We look at optimal employment contracts when workers are heterogeneous and choose search intensity. Firms may want to retain their good workers by matching any offers that these employees may receive from other firms. However, if workers are able to vary their search intensity, this ‘‘offer-matching’’ policy leads to a moral hazard problem. Workers are induced to search more intensively, which is costly. Assuming that firms can commit to retain and employ all workers, irrespective of their ability, we establish conditions under which it is optimal to do so. The idea is that firms can create an adverse selection situation that reduces outside offers from raiding firms. We describe equilibria where all firms use these so-called ‘‘pooling’’ contracts. The intuition is that the gains from reducing the returns to search may outweigh the costs of retaining all workers, including the low ability ones. We also derive conditions under which only ‘‘separating’’ contracts are offered and firms only retain the high ability workers. Some equilibria involve contracts where an ‘‘efficiency wage’’ is paid that again deters workers from actively looking for outside offers. Finally, we show that for a range of parameter values multiple equilibria are also possible.

Keywords: labour market frictions; labour contracts; turnover; search effort; moral hazard and adverse selection. (search for similar items in EconPapers)
JEL-codes: J31 J41 J63 J64 (search for similar items in EconPapers)
Pages: 38 pages
Date: 2003-09, Revised 2004-01
Note: Revised (January 2004) version of my (September 2003) paper entitled Layoffs and Promotions with Heterogeneous Workers and On-the-job Search.
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