Efficiency Wages and Subjective Performance Pay

This paper studies optimal relational contracts in motivating workers in a market setting. We find that labor markets with higher turnover costs will use more subjective performance pay and less efficiency wages and that in those markets, the total wage payment is lower and the equilibrium employment level is higher. Surprisingly, under certain conditions, an increase in turnover costs leads to higher social welfare. Incorporating workers’ search costs, we show that wages are procyclical in booms and are either rigid or countercyclical during recessions. The predictions of the model are consistent with some empirical evidence. (JEL D82, J33, J41, J63)