Performance Pay and Adverse Selection

It is well known in personnel economics that firms may improve the quality of their workforce by offering performance pay. We analyze an equilibrium model where worker productivity is private information and show that the firms' gain from worker self-selection may not be matched by a corresponding social gain. In particular, the equilibrium incentive contracts are excessively high-powered, thereby inducing the more productive workers to exert too much effort and increasing agency costs stemming from the misallocation of effort.