Ebook Incentives, Wages, and Promotions: Theory and Evidence
Human capital accumulation through learning and training both in school and the workplace has become increasingly important in the last decade. A natural and important question to ask is: what is the optimal way to motivate students’ and workers’ efforts in learning and training? Surprisingly, few studies in the agency literature have attempted to answer this question. A distinctive feature of effort in human capital accumulation is that such effort affects the agent’s future productivity as well as current performance. This investment effort is the central element of dynamics in other fields of economics, but has been largely ignored in the agency literature. Thus, we ask three main questions in this paper: (i) what is the optimal incentive contract for an agent’s (human) capital investment? (ii) Does the optimal contract provide any additional insights on the internal wage structure of a firm? and (iii) Can we find any consistent evidence for the optimal contract in data?
Even when an agent’s performance depends only upon his current effort, the optimal contract in a repeated moral hazard model becomes quickly intractable as the number of periods increases (see Rogerson, 1985). Consequently, when an agent’s performance depends on his previous efforts as well as his current effort, analyzing an optimal contract can be potentially very complicated. However, we show that the optimal contract can be remarkably simple. Assuming no discounting, the optimal wage is constant except for the last period, and in this last period, the optimal wage contract relies only upon the last period performance. Therefore, the principal need only monitor the agent’s performance in this last period!
The intuition behind this result is the following: in the last period, in order to induce high effort, the principal must promise a bonus for high performance. Consider the agent’s choice of effort in any previous period. Choosing high (investment) effort increases his productivity in the last period and increases the probability that he receives bonus in the last period. Assuming no discounting, the increase in the expected continuation payoff is large enough to induce high effort, without any explicit bonus contract in any previous period. This result predicts, for example, that workers will work hard early in their careers even without any incentive payments in order to accumulate enough human capital for later promotions. It would also predict that students will work hard early in a semester in order to accumulate enough human capital to pass the exam later.
Among many other potential applications, we focus on internal wage, incentive, and promotion structures within firms. One of the theoretical puzzles in the internal wage structure of firms is that firms often provide both bonus-based incentives and promotion-based incentives at the same time. Theories that explain bonus-based incentives assume verifiable performance, and do not explain why there are large incentives particularly at the time of promotion. Theories that explain promotion-based incentives assume unverifiable performance and do not explain the coexistence of bonus-based incentives. (See, for example, Lazear and Rosen, 1981; Prendergast, 1993; and Kahn and Huberman, 1988.)
First, consider why a principal would use promotion-based incentives when performance is verifiable. Suppose that a worker is promoted to higher job-levels as he continues to accumulate more experience (or human capital), and that monetary incentives are provided at each stage of promotion. That is, a worker with a good performance is promoted with a large wage increase, while a worker with a bad performance is promoted with a smaller wage increase. Our model predicts that the principal need not provide extra incentives to the agent prior to the agent’s promotion. Therefore, for any given worker, wages will be constant within a job-level, and will change only through promotions. This typifies the traditional view of an internal wage structure where wages are attached to jobs. At the same time, because different workers receive different wages within each job-level, it explains recent new findings of internal wage structures that large wage variations exist within job-levels (e.g. Baker, Gibbs, and Holmstrom, 1994a).
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