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Title: Equilibrium Incentive Contracts

Author(s): Espen R Moen and �sa Ros�n

Publication Date: February 2003

Keyword(s): contracts, efficiency, incentives and unemployment

Programme Area(s): Labour Economics

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.

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Bibliographic Reference

Moen, E and Ros�n, �. 2003. 'Equilibrium Incentive Contracts'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=3790