Knowledge that Transforms

I study optimal managerial contracts in two contracting environments. When the investment return is contractible, an optimal contract combines a base salary, golden parachute, and bonus. When the return is not contractible, two types of optimal contracts are studied: a contract with restricted stock and a contract with stock options. These three types of contracts are equivalent: they implement the same outcome and lead to the same expected payoff for the manager, implying that the choice of contractual form is irrelevant in the environment I study. I suggest directions of research for the relevance of different contractual forms.

This article considers a model where the agent is uncertain about his innate ability and instead makes an inference from others’ (namely, the principal’s) perception, as often emphasized in the psychology literature. When the principal has superior knowledge about the agent’s productivity than the agent himself, the principal has an incentive to use promotions strategically to boost the agent’s self‐confidence. Within this framework the optimal promotion policy depends not only on the agent’s current expected ability type but also on the history of his previous job assignments. We use this fact to explain why we rarely observe demotions in organizations.

The existence of counteroffers can lead to a variety of important labor‐market features. This article develops a model of the selective use of counteroffers in which a firm decides whether to extend counteroffers after a worker informs the firm of an alternative offer. We outline factors that can influence the employer’s net value of making a counteroffer and, thus, affect the likelihood of a counteroffer. We provide a new empirical analysis that examines whether proxies for these factors do, in fact, influence the likelihood that a firm would consider a counteroffer to an employee with a competing offer.

This article considers optimal unemployment insurance (UI) in an equilibrium matching framework where wages are determined by strategic bargaining. It compares the outcome with the standard Nash bargaining approach, which can be interpreted as union wage bargaining with an insider/outsider distortion. It also shows that a coordinated policy approach, one that chooses job creation subsidies and UI optimally, generates a much greater welfare gain than a policy that simply varies UI payments by duration.

This article contrasts supporting partnerships through relational contracting and supporting partnerships through formal legal institutions. A large population of players interact in bilateral relationships. Efficiency requires cooperation, but cheating yields a higher short‐term payoff. There is a positive probability that the maximum feasible payoff available to a partnership decreases. Opportunistic behavior makes it impossible to realize the efficient outcome. A legal system can lead to efficient contracting. Without such a system, productive relationships arise in equilibrium if it is costly to initiate new relationships. This type of relational contracting tends to make partnerships last longer than is efficient.