Uncertainty, Pay for Performance and Adverse Selection in a Competitive Labor Market

This paper develops a new rationale for the emergence of pay-for-performance contracts. The labor market is competitive, workers are risk averse and firms risk neutral. The paper shows that in stable environments more productive workers self-select into pay-for-performance jobs because risk is less costly to them than to their less productive counterparts which prefer fixed-salary contracts. When uncertainty is sufficiently large a pooling equilibrium emerges in which all workers have pay-for-performance contracts, thereby reducing more productive workers’ costs of being pooled with less productive workers. The model explains several empirical regularities unaccounted for by alternative models, such as markets where all observed contracts involve pay-for-performance, and also that such markets are more likely to emerge in highly uncertain environments.