Efficiency Wages and Performance Pay

This paper studies contract selection between efficiency wages and subjective performance pay to motivate workers in a market setting. The optimal wage contract (which may be a combination of efficiency wages and subjective performance pay) is determined by turnover costs in labor markets. Specifically, labor markets with higher turnover costs use more subjective performance pay and less efficiency wages. As a result, in these markets the total wage payment is lower and equilibrium employment level is higher. Surprisingly, under certain conditions an increase in turnover costs leads to higher social welfare. In an extended model incorporating workers’ search costs, we show that wages are procyclical in booms, and are either rigid or counter-cyclical during recessions. The predictions of the model are consistent with some empirical evidence. JEL Classification: D82, J33, J41, J63. ∗Department of Economics, The Ohio State University, 405 Arps Hall, 1945 N. High Street, Columbus, OH 43210. Email: [email protected]. †This is a revised version of the second chapter of my dissertation presented to the University of Pennsylvania. I wish to thank Ken Burdett, Bill Dupor, Jan Eeckhout, Paul Evens, Rafael Rob, and seminar participants at the Midwest Theory Conference 2003 at Indiana University at Bloomington for helpful comments and discussions. I am truely indebted to Steven Matthews for his invaluable advice, support and guidance. The usual disclaimers apply.