A Tale of Two Wages: Separating Contract from Governance

This paper distinguishes between governance structure and contractual form. The basic premise is that researchers often confuse these two concepts when they develop or empirically test models within the transaction cost framework. In the paper I utilize a simple principal-agent model to show that transaction cost factors affect both contractual form and governance structure, but not identically. Transaction cost factors that are known to result in employment as a governance structure do not automatically result in contracts characterized by the payment of fixed-wages, as suggested by economic theory. Instead, incentive pay and the delegation of decision-making authority to workers may be preferred by firm owners. The implication is that the relationship between a firm and a worker involves a two stage decision-making process by the firm owner. The first is the choice of governance structure, the second is the nature of the contract linking the worker to the firm. (JEL D23)