Optimal incentive mix: The dual role of promotions and layoffs in firms

Firms offer highly complex contracts to their employees. These contracts contain a mix of various incentives such as fixed wages, bonuses, promise of promotion and threat of firing. This paper aims at explaining the reason why this incentive mix arises. The theoretical model proposed is a job assignment model with heterogeneous employees. In this model the firm is concerned about job assignment because the overall productivity of the firm depends on the quality of the employees and their allocation to jobs. In particular, the purposes of promotions and layoffs become twofold. First, they create incentives for the employees. Second, they work as sorting devices where the firm can adjust the composition of the workforce at any given hierarchical level to maximize profits. These sorting and selection considerations lead to the optimal incentive mix observed in firms. A set of the model’s broader predictions is stated explicitly and tested on the personnel records from a large pharmaceutical company. The model’s conjectures are shown to be consistent with the data. Preliminary draft, please do not quote or distribute