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Prof. Árpád Ábrahám

European University Institute, Florence, Italy

Authors: Árpád Ábrahám, Fernando Álvarez-Parra, and Susanne Forstner

Abstract: Performance-dependent pay is widely observed in labor contracts. In this paper we study the impact of moral hazard in employment relations, as a source of performance pay, on the cross-sectional wage distribution. Our analysis builds on a search model with job-to-job mobility and firm competition 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 vary across different levels of match output. This direct effect of moral hazard increases wage inequality by inducing wage dispersion among workers with the same job offer 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 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. Inequality increase within the lower half of the distribution, however, is much larger. A decomposition of effects shows that limits to incentive provision at low levels of workers' lifetime utility play an important role for the increase in effort costs to firms. As firms adjust effort and wage levels in response, the wage distribution expands substantially at the lower end.

Full Text:  “The Effects of Moral Hazard on Wage Inequality in a Frictional Labor Market”