Many workers receive pay based on subjectively assessed performance, yet the shirking model of efficiency wages excludes it. This paper incorporates such pay, with the following results. Performance pay is more efficient than efficiency wages when the costs of having a job vacant are low and qualified workers in short supply. More capital-intensive industries pay more than less capital-intensive industries, as observed in studies of interindustry wages differentials. Sustaining an efficient outcome requires a social convention similar to the notion of a fair wage. The model also makes predictions about the relationship between turnover, wages, growth, and unemployment.

We analyze incomplete contracts to induce efficient investment. With exogenous switching costs, fixed-price contracts are efficient, generate some rigidity in prices, are renegotiated intermittently by possibly small amounts, and when inflation is positive, generate asymmetric responses to shocks, all consistent with evidence on prices and wages. With two-sided specific investments, efficiency requires prices to have sufficient escalator clauses to avoid renegotiation, as observed in many long-term contracts. A third case, with one-sided specific investments, can generate "take or pay" contracts and explain why firms sometimes pay for specific investments that appear to benefit employees directly.

During the last several decades, a growing body of laboratory research has shown that human subjects do not always choose to maximize material payoffs. Economists following the lead of

This paper extends the standard principal–agent model to allow for subjective evaluation. The optimal contract results in more compressed pay relative to the case with verifiable performance measures. Moreover, discrimination against an individual implies lower pay and performance, suggesting that the extent of discrimination as measured after controlling for performance may underestimate the level of true discrimination. Finally, the optimal contract entails the use of bonus pay rather than the threat of dismissal, hence neither “efficiency wages” nor the right to dismiss an employee are necessary ingredients for an optimal incentive contract.

Stratification is a distinctive feature of competitive education markets that can be explained by a preference for good peers. Learning externalities can lead students to care about the ability of their peers, resulting in across-school sorting by ability. This paper shows that a preference for good peers, and therefore stratification, can also emerge endogenously from reputational concerns that arise when graduates use their college of origin to signal their ability. Reputational concerns can also explain puzzling observed trends including the increase in student investment into admissions exam preparation, and the decline in study time at college.

We begin with two uncontroversial hypotheses - firm productivity is expensive to measure and employment entails relationship-specific investments. These assumptions imply that firms would optimally choose fixed-wage contracts, and complement these with bonus pay when measuring employee performance is not too costly. These assumptions imply that under an optimal employment contract hours of work is less responsive, while total compensation is more responsive to shocks under bonus-pay contracts compared to fixed wage contracts. Using data from the Panel Study of Income Dynamics (PSID) where shocks are proxied using the local unemployment rate, we find strong support for these two implications.