Adverse Selection and Pay Equality

Jay Stewart


Previous studies have shown that adverse incentives can lead firms to weaken the link between pay and performance, which leads to more equal pay across workers. In these models, high-powered incentives encourage workers to neglect some aspects of their job, or to sabotage their co-workers' efforts. This paper offers another explanation for the weak link between pay and performance. When labor contracts are contests, the Nash equilibrium often pools workers. This implies that incentives are weaker than would be the case if firms could observe workers types before contracting and offer each type their respective optimal contests.