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Adverse Selection and Pay Compression
Author(s) -
Stewart Jay
Publication year - 1999
Publication title -
southern economic journal
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.762
H-Index - 58
eISSN - 2325-8012
pISSN - 0038-4038
DOI - 10.1002/j.2325-8012.1999.tb00206.x
Subject(s) - adverse selection , incentive , principal (computer security) , neglect , microeconomics , pay for performance , moral hazard , economics , nash equilibrium , selection (genetic algorithm) , labour economics , principal–agent problem , business , computer science , computer security , finance , medicine , corporate governance , nursing , artificial intelligence
A fundamental result of the principal‐agent literature is that pay will be linked to performance when it is difficult for the principal to monitor the agent's actions. However, performance pay can lead to adverse incentives. In these models, high‐powered incentives encourage workers to neglect some aspects of their job or to sabotage their coworkers' efforts. This paper offers another explanation for the weak link between pay and performance: worker heterogeneity. When workers are heterogeneous and labor contracts are contests, the Nash equilibrium often pools workers. I show that this implies that the link between pay and performance is weaker than would be the case if firms could observe workers' types before contracting and offer each type their respective optimal contests.