Efficiency Wages and Subjective Performance Pay

I. INTRODUCTION How to design incentive schemes to motivate workers is an important topic in economics. The shirking models of efficiency wages, such as Shapiro and Stiglitz (1984), establish that firms need to pay a wage premium (efficiency wages) to motivate workers, with unemployment serving as a punishment device. However, one shortcoming of these models is that performance pay plays no role. One justification for their omission of performance pay is that individual performance may not be verifiable. Nevertheless, if workers' performance is observable and employment relationships are repeated, firms can use implicit bonuses or relational contracts based on workers' subjectively assessed performance to motivate workers. Since subjective performance pay cannot be legally enforced, it has to be self-enforcing. Given that both efficiency wages and subjective performance pay motivate workers, what is the optimal wage contract from the firm's perspective? Will different labor markets (occupations) use different forms of wage contracts? What are the impacts of different forms of wage contracts on unemployment and social welfare? To answer these questions, this paper provides a theory of contract selection in a market setting. In a seminal paper, MacLeod and Malcomson (1998, MM hereafter) provided a model of contract selection between efficiency wages and subjective performance pay. The driving force in their model is the market condition. In a market with more workers than jobs, a firm can always immediately and costlessly fill its vacancy after reneging on the promised bonus. Therefore, no subjective performance pay is credible, and firms have to use solely efficiency wages to motivate workers. On the other hand, in a market with more jobs than workers, efficiency wages are useless in providing incentives because a worker can find another job immediately after being fired. As a result, firms use solely subjective performance pay to motivate workers. In MM, there are no exogenous turnover costs. Complementary to MM, this paper provides a model of contract selection driven by exogenous turnover costs in labor markets. We focus on the situation in which unemployment always exists in labor markets, thus ruling out market condition as a determinant of contract selection. It turns out that turnover costs affect the amount of efficiency wages and performance pay in optimal contracts. While in MM efficiency wages and subjective performance pay cannot be used together to motivate workers, in our model firms are able to use combinations of both methods of payments. By affecting optimal contracts, turnover costs also have impacts on the equilibrium employment level and social welfare. Finally, our model generates rich empirical implications about the relationships among turnover costs, forms of employment contracts, and levels of employment. Our basic model studies how turnover costs borne by firms affect contract selection. From the firm's point of view, subjective performance pay is "cheaper" since efficiency wages entail a wage premium. Thus, the optimal wage contract uses the maximum amount of bonus to motivate workers. However, subjective performance pay may not be credible due to the firm's moral hazard problem: in labor markets with positive unemployment, a firm can immediately hire a new worker after reneging on the implicit bonus. The presence of turnover costs can alleviate this moral hazard problem. This is because a worker can punish a reneging firm by quitting and the firm has to incur turnover costs in hiring new workers. Therefore, in the optimal contract, the amount of bonus is increasing in turnover costs. Since subjective performance pay is cheaper, as the turnover costs increase, more subjective performance pay leads to a lower total wage payment. After deriving the optimal contracts, we turn to study market equilibrium, which is determined by firms' free entry condition. …