Safeguarding Specific Human Capital Investments

When a firm changes its unique mix of products, markets, and technologies, some of employees’ previously acquired human capital depreciates. As a result, the firm can credibly renegotiate down employees’ quasi rents, which it had promised them as a reward for their human capital investments. We show that linking employees’ pay to total firm value, a widely observed phenonemon in practice, can mitigate the firm’s ex post opportunism. Consistent with available empirical evidence, our model implies that firms which link the pay of their rank-and-file employees to total firm value should be, in particular, firms with a high degree of human capital intensity, young firms and firms in dynamic, high-growth industries, such as new economy firms, and firms in risky, volatile industries. ∗University of Frankfurt, CEPR, & ECGI. Address: Johann Wolfgang Goethe-University Frankfurt am Main, Faculty of Economics and Business Administration, Mertonstrasse 17, 60054 Frankfurt am Main, Germany. Email: [email protected] †Corresponding author. New York University, CEPR, & ECGI. Address: Stern School of Business, New York University, 44 West Fourth Street, Suite 9-190, New York, NY 10012. Email: [email protected].