Implicit Employment Contracts: The Limits of Management Reputation for Promoting Firm Productivity

Abstract

Implicit employment contracts are a common way to motivate firm productivity but also require that employees trust management to be fair when allocating post-production firm resources between employees and owners. We use an experiment to study the problem of motivating firm productivity, which depends on levels of both owner investment and employee productive effort, when managers have an incentive to favor the owner's interests over those of the employee. Drawing on research in psychology and behavioral economics, we argue that reputation formation is necessary but not sufficient for promoting firm productivity if manager compensation is highly sensitive to how much the owner is allocated after production occurs. Consistent with our predictions, allowing reputation formation does lead to greater firm productivity and higher payoffs for all firm members, but only when manager pay is relatively insensitive to the owner's ex post allocation. In addition to offering testable empirical implications, our theory and results are important because they can help explain why executive compensation is, in practice, surprisingly insensitive to owner returns, particularly when executives are responsible for maintaining long-term implicit employment contracts.

JEL Classification: M40, M46, J33