CXO

Competition And The Ratchet Effect

Date Added: Sep 2010
Format: PDF

In labor markets, the ratchet effect refers to a situation where workers subject to performance pay choose to restrict their output, because they rationally anticipate that firms will respond to higher output levels by raising output requirements or cutting pay. The authors model this effect as a multi-period principal-agent problem with hidden information, and study its robustness to labor market competition both theoretically and experimentally. Consistent with the theoretical model, they observe substantial ratchet effects in the absence of competition, which is nearly eliminated when competition is introduced; this is true regardless of whether market conditions favor firms or workers.