Motivate and select: Relational contracts with persistent types

• Date: 01 September 2017
• DOI: http://doi.org/10.1111/jems.12201
• Author: Radoslawa Nikolowa
• Published date: 01 September 2017

Received: 6 August 2015 Revised: 3 November2016 Accepted: 3 December 2016

DOI: 10.1111/jems.12201

ORIGINAL ARTICLE

Motivate and select: Relational contracts with persistent types

Radoslawa Nikolowa

School of Economics and Finance,

Queen Mary University of London,

Mile End Road, London E1 4NS, UK

(Email: r.nikolowa@qmul.ac.uk)

Abstract

We develop a model of relational contracts with moral hazard and asymmetric per-

sistent information about an employee’s type. We find that the form of the optimal

contract depends on the job characteristics and the distribution of employees’ talent.

Bonus contracts are more likely to be adopted in complex jobs and when high talent is

not too common or too rare. Firms with “normal” jobs are more likely to adopt termi-

nation contracts. In labor market equilibrium, different contracts may be adopted by

ex ante identical firms. Hence, we offer an explanation for the coexistence of different

employment systems within the same industry.

1INTRODUCTION

Employment contracts are often incomplete and informal reputational mechanisms are prominently used in organizations where

informal codes of conduct affect the behavior of agents. A growing empirical literature documents employers’ use of firing,

promotions, and bonuses based on informal agreements to motivate their employees.1Furthermore, MacLeod and Parent (2015)

empirically show that reputational mechanisms can provide insight into the form of compensation and that job characteristics

affect the nature of the compensation schemes offered to employees.

In this paper, we develop a model of self-enforceablerelational contracts when t he employee’s type is his private information

and the job requires handling tasks with different levels of difficulty.The model allows us to understand how the characteristics of

the job, the labor market, or the firm affect the compensation package used by employers and their hiring and firing policies. We

also show that in labor market equilibrium, aprioriidentical firms may choose to offer different yet equally profitable contracts

that feature different hiring and firing policies. Hence, the paper also helps explain why different employment systems may

coexist within the same industry. In the U.S. manufacturing industry, some firms have adopted flexible organizational structures

with employees’ involvement and teamwork, whereas others have adopted a more rigid job structure aimed at cutting costs

(Osterman, 1994). Hunter (1999) offers evidence of the coexistence of different employment models in the U.S. retail banking

sector, and Bailey and Sandy (1999) examine the different practices in the apparel industry.

In the model, a continuum of heterogeneous workers and a continuum of homogeneous employers play an infinitely repeated

game. Each employee privately observes his talent. An employee’s job consists of handling one task in each period, and the

firm owner’s problem is to motivate the employee to successfully perform this task. To succeed in a task, an employee needs

ability and effort. The more difficult a task is, the more able an employee must be to successfully perform it. Performance is

observable within the relationship but cannot be verified by a third party such as a court of law. An employer will be able to

credibly promise a performance-based bonus only when the rent from retaining an employee is sufficiently high. Because we

focus on cases where jobs are in short supply,t he onlyrent for the employer comes from the potential difference in talent between

I thank the editor Professor Casadesus-Masanell, the associate editor, and two anonymous referees for their thorough and helpful comments. The paperhas

benefited from helpful comments by Daniel Ferreira, Luis Garicano, David Martimort, Jeanine Miklos-Thal, Bernard Salanié, and the participants of the third

edition of the conference “Industrial Organization: Theory,Empirics and Exper iments,” the Econometric Society meeting in Toulouse,and the Microeconomics

seminar in Tilburg. The usual disclaimer applies.

J Econ Manage Strat. 2017;26:624–635. © 2017 WileyPeriodicals, Inc. 624wileyonlinelibrary.com/journal/jems