Layoffs as Part of an Optimal Incentive Mix: Theory and Evidence


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. In particular,
the model focuses on why firms are combining promotions and bonuses with firing. 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 upon the quality of the employees and their allocation to jobs. The
model shows that firing has a dual role. Firing creates incentives for the employees, and
it is used as a sorting device that allows the firm to improve workforce quality. Thus,
quality-concerned firms might want to combine cost-efficient incentives such as promotions
and bonuses with firing. To comply with the Gibbons and Waldman critique, a large set of
the model’s broader predictions is stated explicitly and tested on the personnel records from
a large pharmaceutical company. The model’s predictions are shown to be consistent with
the data.

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