Risk Sharing and Employee Motivation in Competitive Search Equilibrium

This paper incorporates a classical moral hazard problem with unobserved worker effort and bonus payments into a competitive search equilibrium environment with risk averse workers. The resulting framework permits an analysis of the effects of labour market competition and search frictions on individual contract setting. The paper demonstrates that the classical model of moral hazard with an ex-post wage setting regime may underestimate the optimal values of wages and bonus payments in competitive labour markets. The baseline model is extended to account for employer heterogeneity with respect to capital endowments. In the extended model, wage competition between employers serves as a source of positive correlation between wages and bonus payments reported in a number of empirical studies