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Article Excerpt
Firms often augment career concerns incentives with implicit incentive contracts. I formalize the interaction between these two incentives, and highlight its implications on a firm's decision to disclose its workers 'productivity information. Disclosure enhances career concerns but inhibits implicit contracts. I show two main results. First, implicit contracts weaken (i.e., substitute) career concerns if the prior belief about the worker's ability is low, and vice versa. Second, when these incentives are substitutes, the optimal disclosure policy follows a cutoff rule: patient firms are opaque, and transparent firms never offer implicit contracts. These results need not hold if the incentives are complements.
1. Introduction
* In providing incentives to their workers, firms often augment career concerns incentives with implicit incentive contracts that promise performance-based bonus payments. Such incentive provisions are frequently observed in some industries such as financial services, information technology, and so on. There is considerable evidence of career concerns among mutual fund managers (Chevalier and Ellison, 1999). Bonus payments also constitute a significant portion of the fund manager's total pay packages. Information technology professionals face strong career concerns incentives, because a better engineer often gets higher wage offers from the external labor market (Loveman and O'Connell, 1996). The use of bonus payments as an incentive device is also prevalent in this industry, and often aids in the retention of IT professionals (Agarwal and Ferratt, 1999). (1)
The strength of career concerns incentives depends on how closely the outside labor market can observe the worker's performance, because the prospective employer's wage offer is based on her "beliefs" about the worker's productivity. However, when hiring an experienced worker, the prospective employer may surfer from an informational disadvantage. The initial employer typically possesses better information about the productivity of her workers, as she may have also observed the worker's performance in the past (Waldman, 1984). Hence, the initial employer may disclose this information strategically in order to influence the beliefs of the prospective employers, and consequently can manipulate the career concerns incentives of her workers. (2)
There are different channels of information transmission through which the market may attempt to learn, or through which the firm may influence the market's learning about a worker's productivity. A commonly used channel is the extent of worker/client interaction. For example, an IT firm can decide whether to send a worker to the client's site to do the project, or to complete the project in its own facility and send back the final product. In the first case, the firm is completely transparent. The client firm can easily identify the better workers. In the latter case, the firm is opaque. The client firm gets no information on an individual worker's productivity, and there is no room for career concerns incentives. (3) Promotion announcements or assignment to job titles are also commonly discussed as channels of information disclosure. (4,5)
A firm's disclosure decision must balance a tradeoff when it attempts to augment career concerns incentives with implicit contracts. Although disclosure enhances career concerns incentives, it may lessen the firm's ability to sustain implicit contracts that promise performance-based bonus payments. Implicit contracts are sustained through the threat of future retaliation by the workers, which is initiated if the firm reneges on its bonus promises. However, a transparent firm can continue to rely on its workers' career concerns incentives even if it reneges on its bonus promises. In other words, the payoff of a transparent firm following a breakdown of the implicit contract (i.e., on the punishment path) is higher than that of its opaque counterpart. Consequently, under transparency, the firm's temptation to renege on its promises is higher, which lowers the firm's ability to sustain implicit contracts.
The purpose of this article is to study the role of disclosure in such an environment. It formalizes the aforementioned tradeoff associated with a firm's transparency decision, and brings out two substantive issues. First, it highlights the interaction between implicit contracts and career concerns incentives; second, it characterizes the optimal disclosure policy of the firm, and studies how the nature of interaction between these two incentives influences the firm's disclosure decision.
I consider a model where an infinitely lived principal ("firm") hires a sequence of short-run agents ("managers"). Each manager lives for two periods, and in the second period, he may be raided (i.e., "poached") by the outside labor market. In period 1, the manager brings an investment project to the firm. The project quality ("good" or "bad") depends only on the manager's ability. The ability of the manager is unknown to all players (including the manager himself), but follows a known prior distribution. Before the project is implemented, both the firm and the manager observe a signal ("good" or "bad"), which is informative of the underlying project quality. The manager can increase the precision of the signal by exerting effort. The firm implements the project if the signal is good. The true project type is subsequently revealed. The period 2 productivity of the manager is exactly equal to his ability.
The firm commits to a disclosure policy (i.e., whether to be transparent or opaque) at the beginning of the game. A transparent firm reveals all information about the manager's output, whereas an opaque firm does not reveal any. At the end of the first period of a manager's life, the raiders bid competitively for the manager. Observing the bids, the firm submits a counteroffer, and the manager chooses his period 2 employer. He leaves the environment at the end of period 2, and a new generation of manager is hired by the firm. Because the raiders infer the manager's ability by observing his output and bid accordingly, the manager has career concerns in a transparent firm.
The firm provides incentives through two channels. It can potentially rely on the career concerns of the manager and, in addition, it can offer bonus payments sustained through implicit contracts. If the firm reneges upon its implicit contract, future generations of managers play their static best response (trigger strategy). So, the effort that the firm can elicit from the managers on the punishment path is solely based on the managers' career concerns incentives.
This article brings out two main results. First, if the prior expectation of the manager's ability is high, incentives from bonus payments enhance (i.e., complement) career concerns incentives, and attenuate them (i.e., substitute) otherwise. The argument is simple, yet subtle. The market expects the manager to work harder when his bonus payment is increased. If the manager fails in spite of working harder, the market interprets it as a stronger signal of the manager's underlying low ability. Consequently, the market evaluates him more harshly than before. If the manager's expected ability is high, it is more likely that he will succeed if he works hard. Thus, he works even harder in order to succeed and to avoid such harsh market evaluation. In contrast, if the manager's expected ability is low, it is likely that he will fail even if he works harder. Such a manager may find it optimal to reduce his effort so that the market may attribute his failure (at least partially) to his low effort, rather than interpreting it as a strong signal of his low ability. Observe that in the former case, the manager puts in extra effort to reveal his true ability, which he (and everybody else) expects to be good, whereas in the latter case he reduces his effort to bide his true ability, which he (and everybody else) expects to be bad.
Second, I show that when the prior expectation of the manager's ability is low, disclosure policy follows a cutoff rule. That is, the firm opts to be transparent if and only if its discount factor is below a certain threshold. Moreover, a transparent firm does not offer any bonus payment. These results need not hold if the prior expectation about the manager's ability is high. In such case, the optimal disclosure policy need not follow a cutoff rule, and a transparent firm may find it optimal to offer bonus payments.
This result suggests that the nature of interaction between the two types of incentives plays a crucial role in governing the firm's optimal disclosure policy. What drives the cutoff rule? Clearly, a firm with low reputation concerns (i.e., low discount factor) may not be able to credibly promise a high enough bonus, and prefers to be transparent to take advantage of the career concerns incentive. However, a firm with high reputation concerns (i.e., high discount factor) prefers to be opaque. Although the complete argument is a bit involved (discussed later in Section 5), the basic intuition is as follows. Consider an opaque firm with enough reputation concerns such that it can credibly promise a bonus that can induce an effort level that is at least as high as the career concerns effort level. There is a case for transparency only if this firm can profit by augmenting career concerns incentives with bonus incentives (also recall that a transparent firm must settle for a lower bonus incentive compared to its opaque counterpart). My first result suggests that if the prior expectation on the manager's ability is low, under transparency, the impact of a bonus payment on effort is weaker (compared to the opaque case) due to a dampened career concerns incentive. Thus, such a firm can do better by relying only on bonus payments (under opaqueness) rather than exposing its manager to both career concerns and bonus incentives simultaneously. There is no case to be made for transparency for such a firm.
However, this argument breaks down when bonus payments enhance (or complement) career concerns. This is the case when the prior expectation of a manager's ability is high. By exploiting the complementarity between the two incentives, the firm creates a greater impact on its manager's effort by applying both incentives simultaneously than what it can do by applying each of these incentives in isolation. Therefore, the optimal disclosure policy need not follow a cutoff rule. Moreover, a transparent firm may find it optimal to offer bonus payments.
This result leads to some interesting testable hypotheses. For example, one empirical implication of this result is that in an environment where talent is scarce, firms with low reputation concerns are more likely to opt for transparency.
** Related literature. This article relates to two strands of literature--implicit contracts and career concerns--and attempts to bridge the two.
Several authors have discussed the role of implicit contracts both as incentive mechanisms (Bull, 1987; MacLeod and Malcomson, 1989; MacLeod, 2003; Levin, 2003) and in defining the boundaries of a firm (Baker et al., 2001, 2002). Although these authors take the firm's ability to sustain an implicit contract as a given, I endogenize it through the firm's disclosure policy.
The idea of career concerns as a disciplinary device dates back to Fama (1980), and subsequently formalized by Holmstrom (1982) (also see Scharfstein and Stein, 1990). These authors assume symmetric information between the initial and future employer(s) of a worker. In this article, in contrast, I allow for asymmetric information among employers. Therefore, it relates more closely to the works that consider the effect of varying amounts of information in a career concerns setting. For example, Jeon (1996) discusses the role of teams in filtering information. Allocation of power in a firm can also affect information disclosure, as studied by Ortega (2003). Gibbons and Waldman (1999) offer a survey on this topic. However, in contrast with this article, these authors do not consider the effect of information disclosure on a firm's ability to sustain implicit contracts.
Even though the interaction between implicit and explicit incentives in a firm is well studied (Gibbons and Murphy, 1992; Dewatripont et al., 1999a, 1999b), the interplay between career concerns and implicit contracts, and the role of organizational transparency in combining these two incentives have largely gone unnoticed. This article attempts to reconcile this gap.
Perhaps the paper that is more closely related to my work is by Baker et al. (1994), which characterizes the optimal contract when the firm combines incentives through implicit contracts with explicit incentives. Similar to this article, the authors assume that the firms resort to optimal explicit incentives in the case the implicit contract breaks down. However, because the firm cannot commit to implement a certain explicit contract every period, its punishment payoff is independent of the explicit contract it offers in equilibrium. In contrast with Baker et al., I allow the firm to commit to a certain level of punishment payoff by choosing an irreversible disclosure policy up front. Such an assumption on commitment also bears relation to Halonen (2002). She studies the tradeoff associated with the optimal ownership allocation in long-run relationships when such an allocation cannot be renegotiated on the punishment path. The tradeoff illustrated in this article, although similar in spirit with Halonen, originates in a completely different context (i.e., the interplay of implicit contracts and career concerns).
Finally, this article also relates to the literature on adverse selection in the labor market (Greenwald, 1986). I discuss how a firm's disclosure decision endogenizes the implications of the adverse selection problem, and how it affects worker turnover. However, I neutralize this effect in my model to stay focused on the key tradeoff between career concerns and implicit contracts.
The organization of this article is as follows. The next section develops a model that captures the aforementioned tradeoff. Section 3 develops some preliminary results that are useful for the main analysis. In Section 4, I analyze the interaction between career concerns and...
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