Misaligned Managerial Incentives and Employee Wage Schedules

Abstract

We model a multidivisional firm as a three-tier economic organization. The larger the number of divisions, the lower is the owner's capacity to monitor delegated managers. We show how resultant misaligned managerial incentives can translate into differences in employee incentive schemes between small and large firms producing the firm-size wage effects. We endogenize the owner's decision to impose payroll cost controls. The compression of ratings can be an equilibrium outcome of the agency problem between the manager and the employee with cost controls.

Keywords: Delegated contracting, misaligned managerial incentives, soft budget, cost controls, large-firm wage premium, compression of ratings

JEL Classification: D21, J30, M52