Questions: Incentive Design and Personnel Economics

Question 1

Lazear's deferred compensation model predicts that workers are underpaid relative to their marginal product early in their careers and overpaid later. The incentive mechanism works because...

• A. Workers become more productive over time due to human capital accumulation
• B. Workers who shirk risk being fired and losing the above-marginal-product wages they would have received later — the future overpayment serves as a bond against shirking
• C. Firms use seniority-based pay because it is administratively simpler
• D. Workers prefer increasing wage profiles due to hyperbolic discounting

Answer: (B)

The key insight is that the upward-sloping age-earnings profile is not simply a return to experience — it is an incentive device. By backloading compensation, the firm creates a situation where workers have something to lose (the future premium over marginal product) if they are caught shirking. The worker effectively posts a bond through years of below-marginal-product wages early in the career. This explains mandatory retirement (otherwise, firms would want to terminate overpaid senior workers) and why long-tenure workers earn more than equally productive new hires — the tenure premium is a return on the implicit bond, not a return on skills.

Question 2

In a tournament model of promotion (Lazear and Rosen, 1981), worker effort depends primarily on their absolute output level.

• T. True
• F. False

Answer: False

In tournaments, what matters is relative rank, not absolute output. Workers compete against each other, and the one with the highest output (or performance evaluation) wins the promotion and the associated pay increase. Effort incentives depend on the prize spread (the difference between winner and loser pay) and the number of competitors, not on absolute performance thresholds. This has several implications: common shocks (a bad economy, a difficult assignment) do not change incentives because they affect all competitors equally; the optimal prize spread increases with the difficulty of monitoring individual effort; and tournaments can generate sabotage or excessive risk-taking if the prize spread is very large relative to base pay.

Question 3

Why might a firm choose to pay efficiency wages (above market-clearing wages) rather than use piece rates or monitoring to motivate workers?

Model answer: Efficiency wages are optimal when individual output is difficult or costly to measure (making piece rates infeasible), when monitoring is expensive or imperfect, and when the cost of worker malfeasance is high. By paying above the market wage, the firm makes job loss costly to workers — the gap between the current wage and the worker's next-best option (the 'employment rent') motivates effort because shirking risks detection and termination. The premium replaces direct monitoring: workers self-discipline because the consequences of being caught are severe. Efficiency wages also reduce turnover (saving recruitment and training costs) and may attract higher-quality applicants through adverse selection effects.

Shapiro and Stiglitz (1984) formalized this as a no-shirking condition: the wage must be high enough that the expected cost of shirking (probability of detection times the employment rent lost) exceeds the benefit of reduced effort. In equilibrium, all firms pay above the market-clearing wage, creating involuntary unemployment — which is itself part of the incentive mechanism, because unemployment makes job loss even more costly. This provides a microfoundation for involuntary unemployment based on incentive considerations rather than wage rigidity.