The Role of Turnover Costs in the Enforcement of Performance-Related Pay Contracts

Labour contracts which establish performance-related pay are afflicted with the firm's moral hazard problem because of the difficulty in the verifiability of performance by an external authority. Some models have explored the possibility that such contracts could be enforced through a mechanism of the firm's reputation or thanks to an excess of demand in the labour markets (unfilled job vacancies). In this paper a simple model is proposed to show the working of an alternative mechanism for performance-related pay contracts based on turnover costs, borne by firms arising from the process of hiring, training and firing. By sinking a certain amount of resources as turnover costs, employers may credibly promise to pay a bonus, if faced with the worker's threat to quit in the case of cheating, to avoid the loss of specific capital. This provides a formalization of the insight that turnover costs and specific investments might support the enforcement of implicit contracts. The welfare implications of this mechanism are worked out, showing how turnover costs on the one hand reduce the available social surplus but on the other hand increase this surplus by providing incentives for optimal effort