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Working Papers

October 2017, No. 17-11R

Optimal Incentive Contracts with Job Destruction Risk

Borys Grochulski, Russell Wong and Yuzhe Zhang

Although the canonical dynamic moral hazard model (Sannikov 2008) can generate endogenous job separations, they are extremely rare: in a standard parametrization, the expected job duration exceeds 400 years. To generate a much shorter expected job duration consistent with the data, we extend the model by adding exogenous separations modeled as Poisson job destruction shocks. We study the implications of job destruction risk for an optimal incentive contract, the firm's profit, the agent's compensation, and severance. At job destruction, the firm always loses but the agent may gain. With sufficient risk aversion, the optimal contract has exactly two regions. If the agent's continuation value is below a threshold, the agent faces negative jump risk at job destruction. Above this threshold, the jump in the agent's continuation value at job destruction is positive. The risk of exogenous job destruction changes the qualitative properties of the optimal contract: it completely displaces the risk of "golden parachute" separations, where the agent becomes too rich to respond to incentives. We show that job destruction risk exacerbates the moral hazard friction by limiting the scope for incentive backloading. This generates a new channel for explaining positive wage-tenure profiles observed in the data.


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