Implicit vs. Explicit Incentives: Theory and a Case Study
40 Pages Posted: 19 May 2009
Date Written: May 2009
We derive the optimal contract between a principal and a liquidity-constrained agent in a stochastically repeated environment. The contract comprises a court-enforceable explicit bonus rule and an implicit fixed salary promise that must be self-enforcing. Since the agent's rent increases with bonus pay, the principal implements the maximum credible salary promise. Thus, the bonus increases while the salary promise and the agent's effort decrease with a higher probability of premature contract termination. We subject this mechanism to econometric testing using personnel data of an insurance company. The empirical results strongly support our theoretical predictions.
Keywords: implicit contract, explicit bonus pay, premature contract termination, compensation and productivity estimates
JEL Classification: J3, M5
Suggested Citation: Suggested Citation