This paper considers the enforceability of employment contracts when employees' performance cannot be verified in court so that piece-rate contracts are not legally enforceable. Part I shows that there exists a variety of self-enforcing implicit contracts, modelled as perfect equilibria in a repeated game, and characterizes all the wage and performance outcomes that can be implemented. Implementation requires a strictly positive surplus from employment, the form of the contract depending on how this surplus is divided between firm and employee. Piece-rate contracts, and contracts with an informally agreed bonus, can be made self-enforcing but the use of severance pay and bonding does not extend the set of implementable allocations. The resulting contracts resemble actual labor contracts more than do the contracts in standard principal-agent models. Part II analyses market equilibrium with these contracts, also modelled as perfect equilibria in a repeated game, and shows that many such equilibria exist. Unfilled vacancies and unemployed workers can co-exist despite the existence of contracts that are potentially mutually beneficial. For those jobs that are filled, any division of the potential surplus is possible so that the market can have, at the same time, involuntary unemployment and vacancies that are unfilled despite filled jobs earning positive profits. As a criterion for selecting equilibria, a notion of renegotiation proofness is applied. Then either all workers are employed or all jobs filled but any division of the potential surplus is still possible. The paper explores what further restrictions on beliefs give rise to a Walrasian outcome, in which all the potential surplus goes to the short side of the market, and to an efficiency wage type outcome, in which the potential surplus goes to the long side.

The employment relationship with employees' ability and their actions both private information (thus combining adverse selection with moral hazard) is modeled as a repeated game with self-enforcing contracts being perfect Bayesian Nash equilibria. Under termination contracts, the equilibrium contract structure consists of a hierarchy of ranks, finite in number even though ability is continuous. Reputation acts as an effective device for worker discipline without the need for involuntary unemployment. Selection by bonding is not, in general, incentive compatible, but selection by promotion of employees through the ranks is. Many other features correspond to observed employment structures.

Expert performance is often evaluated assuming that good experts have good outcomes. We examine expertise in medicine and develop a model that allows for two dimensions of physician performance: decision making and procedural skill. Better procedural skill increases the use of intensive procedures for everyone, while better decision making results in a reallocation of procedures from fewer low-risk to high-risk cases. We show that poor diagnosticians can be identified using administrative data and that improving decision making improves birth outcomes by reducing C-section rates at the bottom of the risk distribution and increasing them at the top of the distribution.

Workers paid by the piece should be happy to introduce new techniques that increase output, but firms always seem to reduce the piece rate when workers start earning too much money. Workers respond by restricting output and keeping good new ideas to themselves. We show that this outcome is inevitable in a competitive environment. However, there are noncompetitive situations where firms can use piece rates to get cooperation from their workers. These predictions are consistent with case history evidence from the cotton spinning industry in England in the nineteenth century and the Lincoln Electric Company in the United States even today.

In the 1980s and 1990s many states adopted tort reforms. It has been argued that these reforms have reduced the practice of defensive medicine arising from excess tort liability. We find that this does not appear to be true for a large and important class of cases—childbirth in the United States. Using data from national vital statistics natality files on millions of individual births from 1989 to 2001, we ask whether specific tort reforms affect the types of procedures that are performed, and the health outcomes of mothers and their infants. We find that reform of the Joint and Several Liability rule (or the “deep pockets rule”) reduces complications of labor and procedure use, whereas caps on noneconomic damages increase them. We show that these results are consistent with a model of tort reform that explicitly allows for variations in patient condition.

Wage and unemployment responses to changes in economic environment are compared for efficiency wage and frictional models. Changes in aggregate demand, persistence of job-specific shocks, cost of living, and unemployment benefits are considered. Wages and unemployment move in the same direction in the two models, except that an upward shift in aggregate labor demand can reduce the real wage in the efficiency wage, but not the frictional, model. In a numerical simulation calibrated to U.S. data, real productivity shocks in the efficiency wage model yield a ratio of unemployment to wage variability close to that of the United States.

Treatment for depression is complex, requiring decisions that may involve trade-offs between exploiting treatments with the highest expected value and experimenting with treatments with higher possible payoffs. Using patient claims data, we show that among skilled doctors, using a broader portfolio of drugs predicts better patient outcomes, except in cases where doctors' decisions violate loose professional guidelines. We introduce a behavioral model of decision making guided by our empirical observations. The model's novel feature is that the trade-off between exploitation and experimentation depends on the doctor's diagnostic skill. The model predicts that higher diagnostic skill leads to greater diversity in drug choice and better matching of drugs to patients even among doctors with the same initial beliefs regarding drug effectiveness. Consistent with the finding that guideline violations predict poorer patient outcomes, simulations of the model suggest that increasing the number of possible drug choices can lower performance.

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.

An increasing fraction of jobs in the U.S. labor market explicitly pay workers for their performance using bonus pay, commissions, or piece-rate contracts. Using data from the Panel Study of Income Dynamics, we show that compensation in performance-pay jobs is more closely tied to both observed and unobserved productive characteristics of workers than compensation in non-performance-pay jobs. We also find that the return to these productive characteristics increased faster over time in performance-pay than in non-performance-pay jobs. We show that this finding is consistent with the view that underlying changes in returns to skill due, for instance, to technological change induce more firms to offer performance-pay contracts and result in more wage inequality among workers who are paid for performance. Thus, performance pay provides a channel through which underlying changes in returns to skill get translated into higher wage inequality. We conclude that this channel accounts for 21% of the growth in the variance of male wages between the late 1970s and the early 1990s and for most of the increase in wage inequality above the eightieth percentile over the same period.

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.