Moral hazard and overlapping generations with endogenous occupational choice

This paper introduces a general equilibrium, overlapping generations model of the principal- agent problem. Bargaining power, occupational choice, and the returns to each occupation are endogenous. Individuals live for two periods and must work when young. When old, they have a choice between becoming principals or remaining agents. Successful workers are paid high wages and may become self financed principals when old; unsuccessful workers are paid low wages and can become principals only by borrowing money. In a “high wage” equilibrium, an imperfect credit market (which makes it costly to borrow money due to, for example, moral hazard between lender and borrower) mitigates the moral hazard problem on the labor market: young workers work harder than in the static model (for a given wage) in order to succeed and become self-financed principals (the “American Dream” effect). The extra effort makes it possible for principals to pay high wages. However, there is a coordination problem. For the same parameter values that give rise to the “high wage” equilibrium, there also exist equilibria where wages are so low that even successful agents need to borrow money if they are to become principals. Effort is then low because wages are low, and because there is no “American Dream”.