The Effects of Moral Hazard on Wage Inequality in a Frictional Labor Market∗

Abstract

Performance-dependent pay is widely observed in labor contracts. In this paper we study the impact of performance pay, due to moral hazard, on the cross-sectional wage distribution. Our analysis builds on a search model with job-to-job mobility and competition among firms for workers. Firms offer long-term contracts to risk-averse workers in the presence of repeated moral hazard and two-sided limited commitment. In order to provide incentives to workers, wage payments need to depend on realized match output. This direct effect of moral hazard increases wage inequality by inducing wage dispersion among workers with otherwise identical histories. In the presence of on-the-job search and limited commitment, however, moral hazard also affects the wage distribution through several indirect channels, as incentive provision through wage variation increases the costs of worker effort to firms. For a quantitative analysis, we calibrate the model to match characteristics of the U.S. labor market in the mid-2000s. We find that, overall, the presence of moral hazard increases wage inequality by around ten percent. Within the lower half of the distribution, however, the increase in inequality is much larger. A decomposition of effects shows that limits to incentive provision in low-wage states significantly contribute to the increase in effort costs to firms. As a consequence, firms decrease effort levels prescribed and wages paid to their workers, and the wage distribution expands substantially at the lower end.

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Cite this paper

@inproceedings{brahm2015TheEO, title={The Effects of Moral Hazard on Wage Inequality in a Frictional Labor Market∗}, author={{\'A}rp{\'a}d {\'A}brah{\'a}m and Fernando {\'A}lvarez-Parra and Susanne Forstner}, year={2015} }