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Working Papers

May 2013, No. 13-05R

Market-based Incentives (Revised May 2016)

Borys Grochulski and Yuzhe Zhang

In this paper, we study market-induced, external incentives similar to career concerns jointly with standard, contractual incentives linking compensation to performance. We consider a dynamic principal-agent problem in which the agent's outside option is determined endogenously in a competitive labor market. In equilibrium, strong performance increases the agent's market value. When this value becomes sufficiently high, the threat of the agent quitting forces the principal to increase the agent's compensation. The prospect of obtaining this raise gives the agent an incentive to exert effort, which reduces the need for standard incentives. In fact, whenever the agent's option to quit is sufficiently close to being "in the money," the market-induced incentive eliminates the need for standard incentives altogether: compensation becomes completely insensitive to current performance.

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