Moral Hazard and Merit Rating Over Time: An Analysis of Optimal Intertemporal Wage Structures

Abstract

In situations of uncertain worker productivity and risk aversion, labor market contracts have a dual objective of promoting incentives and risk spreading. A trade-off between these objectives is present in single period models as well as in the multi-period models that were the focus of this paper. When there is more than a single period, there will be a divergence between the within period expected productivity and the spot expected wage rate as the wage structure is utilized to promote the creation of work incentives. In effect, firms will merit rate workers on an actuarially unfair basis when viewed within the context of the second period. No single type of influence results, as the impact differs depending on whether or not the worker is productive in the initial period. Following an initial period of being productive, the wage structure will slope upward more than it otherwise would and there will be a narrower within period gap in the wages across productivity states. Similarly, after an adverse productivity outcome, the drop in wages will be accentuated and the risk spreading properties of the second period wage contract reduced. The common element in each of these cases is a reliance on the wage structure to promote incentives. In addition, the intrinsic trade-off between risk and incentives that is present in single period models extends to multiple periods as there is a desire to sacrifice some of the risk spreading capability of period two compensation to bolster the work incentives in an earlier period.