Incentive contracts and unemployment

We study a labour market in which ...rms can observe workers’ output but not their e¤ort, and in which a worker’s productivity in a given ...rm depends on a worker-...rm speci...c component, unobservable for the ...rm. Firms o¤er wage contracts that optimally trade o¤ effort and wage costs. As a result, employed workers enjoy rents, which in turn create unemployment. We show that the incentive power of the equilibrium wage contract is constrained socially e¢cient in the absence of unemployment bene...ts. We then apply the model to explain the recent increase in performance-pay contracts. Within our model, this can be explained by three di¤erent factors: (i) increased importance of non-observable e¤ort, (ii) a fall in the marginal tax rate, (iii) a reduction in the heterogeneity of workers performing the same task. The likely e¤ect of all three factors is an increased equilibrium unemployment rate.