Reputation and Hierarchy in Dynamic Models of Employment

This paper explores the nature of employment contracts in a dynamic model when workers vary by unobserved ability, and there is moral hazard on both sides of the contract. We find that even though a worker's ability is chosen from a continuum, the equilibrium contract is characterized by a hierarchy consisting of a finite number of ranks. Reputation effects are modelled as a Bayesian game, and are needed to ensure workers will not shirk. Workers are not immediately assigned to the appropriate rank, but are promoted through the ranks until they reach a level consistent with their ability.