Incentives, Productivity, and Labor Contracts

Summary

The relationship between age-earnings profiles and worker incentives is examined by contrasting wage and salary workers with the self-employed. It is argued that the steepness of wage and salary workers' age-earnings profiles reflects the desire to provide work incentives to those workers. Since self-employed workers do not face this agency problem, they are used as a benchmark to gauge productivity. Empirical support of the proposition is provided, and the effects of human capital accumulation are separated empirically from incentive effects. The most important conclusion is that under some strong assumptions, most of the slope in age-earnings profiles is accounted for by the desire to provide incentives, rather than by on-the-job training.

INTRODUCTION

Attention has been focused recently on the notion that worker productivity is not independent of the compensation scheme. Starting with early papers by Johnson [1950], Cheung [1969], and Ross [1973], a recurring theme of the agency literature is that a divergence of interests between principal and agent causes output to depend upon the contingent nature of compensation. A seemingly unrelated empirical phenomenon has also been observed (see Wolpin [1974] and Fuchs [1981]). That is that age-earnings profiles for self-employed are flatter than those for otherwise similar wage and salary workers. This is surprising, since investment in physical capital depresses observed wages for the young self-employed, while returns to that investment which accrue to the old, raise observed wages.