The Equilibrium Value of Employee Ethics

We propose a model in which employees differ in both skills and ethics. Employees receive a private, nonverifiable signal about the quality of their project, and decide whether or not to undertake it. Skilled employees lead more projects to success than unskilled ones. Ethical employees internalize the overall costs and benefits of a project whereas strategic employees make their decision based solely on personal rewards (i.e., future wages). Hence, both skills and ethics are valuable to firms, which is reflected in how employee wages vary with firms’ beliefs about an employee’s type given his history. The model’s main tension comes from the fact that a strategic employee keeps the option of showcasing his skills when he undertakes a project whereas, since ethical employees drop all negative-NPV projects, he improves his ethical capital when he drops a project. We characterize equilibrium employee decisions and wages and derive comparative statics, first in a one-period model with exogenous wages and then in a two-period model that endogenizes the value of skills and ethics. An inefficient equilibrium emerges when ethics are not prominent or skills are highly valuable to firms. In this equilibrium, skilled employees undertake more negative-NPV projects than their unskilled counterparts, as they rely on their skills to recoup the bad information they initially receive. In this way, the presence of ethics among some employees disciplines the behavior of strategic ones to make decisions more aligned with overall value. Because the disciplining effect is stronger on low-skill employees, the need for interventionist governance solutions is reduced. The authors would like to thank Steve Tadelis and Felipe Varas for their comments and suggestions on early ideas related to this project. Also providing useful comments and suggestions were seminar participants at Duke University, the Toulouse School of Economics, and FINRA. All remaining errors are the authors’ responsibility. Fuqua School of Business, Duke University, 100 Fuqua Drive, Durham, NC 27708-0120, [email protected], (919) 660-8025. Fuqua School of Business, Duke University, 100 Fuqua Drive, Durham, NC 27708-0120, [email protected], (919) 660-7683. Please note that this paper is still work in progress. In particular, the proofs to the paper’s various results are not all included in this version. As such, please do not circulate the paper or cite it without the authors’ permission.