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Incentive Contracts and the Allocation of Talent

Authors


  • The author is grateful to Luis Garicano and Stephen Redding for their guidance. I thank the editor, Frederic Vermeulen, and two anonymous referees for suggestions that greatly improved the article. I thank Ricardo Alonso, Oriana Bandiera, Odilon Camara, Wouter Dessein, Robert Gibbons, Tony Marino, John Matsusaka, Kevin J. Murphy, Andrea Prat, Heikki Rantakari, Frederic Robert-Nicoud, Daniel Sturm, John Van Reenen and seminar participants at LSE, USC and the University of Munich for their helpful comments.

Abstract

This article develops a theory of sorting that links ability, pay-performance sensitivity and pay levels. Firms employ managers to improve productivity. Because of limited liability, firms use incentive contracts to elicit managerial effort; the type of optimal contract depends on a manager's ability. In equilibrium, individuals are sorted based on ability into production workers, business owners, managers paid an ability-invariant bonus, and managers whose pay varies with ability and firm size. The model generates predictions regarding the effects of technological progress and product competition on the distributions of wages, pay structure and employment across a wide range of managerial levels.

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