Intra-Firm Rent Seeking And Optimal Incentives In Firms

This paper studies how intra-firm rent seeking affects optimal incentives in firms. An incentive-based wage schedule may generate rent seeking within the firm when contracts are incomplete, or when effort is difficult to observe. An egalitarian wage schedule on the other hand weakens workers' incentive to work hard. This trade-off in a model where firms compete for market shares and workers choose the wage schedule as well as between investing in productive activities and intra-firm rent-seeking activities was analyzed. Due to the effects of free-riding, the rent-seeking mechanism and the strategic interaction between firms; large firms tend to adopt wage schedules based on effort. This result is in line with empirical evidence.