Market-based Incentives

We study optimal incentives in a principal-agent problem in which the agent's outside option is determined endogenously in a competitive labor market. In equilibrium, strong performance increases the agent's market value. When this value becomes sufficiently high, the threat of the agent's quitting forces the principal to give the agent a raise. The prospect of obtaining this raise gives the agent an incentive to exert effort, which reduces the need for standard incentives, like bonuses. In fact, whenever the agent's option to quit is close to being ``in the money,'' the market-induced incentive completely eliminates the need for standard incentives.