Using the Compensation Scheme to Signal the Ease of a Task

The literature on principal-agent models has been mainly concerned with two aspects of the princi-pal's problem: (a) choosing the optimal compensation scheme to motivate the agent to implement the " right " amount, or type, of effort in accordance with the principal's objectives; and (b) choosing the scheme that will " sort " the agents according to their underlying (and unobservable) ability. have all looked at various aspects of these problems and have presented results with respect to the nature of the specific schemes that accomplish these goals. We depart from this by focusing on the firm's ability to hire agents by offering the right compensation scheme. We investigate the principal's problem of convincing the agent that she will earn significant compensation if she joined the firm. In particular, we focus on a context in which the firm has private knowledge about the marginal productivity of effort inside the firm. Thus, this is distinct from the adverse selection literature in which the agent is assumed to possess private information. We present results on the shape and power of the optimal compensation scheme in this context. We also discuss the extent to which the shape of the scheme can serve as a credible signal of the firm's underlying marginal productivity. Finally, we present results from a series of experiments which are consistent with the developed theory.