Optimal incentive contracts for knowledge workers

We study optimal incentive provision for “knowledge workers”, a crucial resource for many organizations. We augment a standard moral-hazard framework to reflect two key patterns: First, retention is a challenge because workers are free to leave; thereby harming their employer. Second, the value of the worker׳s outside option might depend on effort on the job. Optimal contracts that retain workers exhibit properties such as first-best effort and surplus, or non-responsiveness to changes in underlying conditions. Due to large rents, full retention is, however, costly for employers. Hence, even when socially inefficient, separation might occur in equilibrium. •We study optimal incentive provision for “knowledge workers” whose retention is particularly important for employers.•Incentivizing knowledge workers is a challenge as they are free to leave, and effort on the job determines their available outside option.•However, retaining them turns out to be particularly costly for employers due to large rents.•Retention may nevertheless lead to first-best incentives and surplus.•Still, employers may optimally induce turnover, even when this is inefficient.