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Working paper

The Cost of Non-Decreasing Pay: Tenured Academics and Civil Servants

Morfov S. G.
This paper formally analyzes the optimal implementation of compensation schemes where the wage cannot decrease in time. Such arrangements are commonly applied to tenured academics and civil servants. We use a finite-horizon model of moral hazard to analyze the disincentive effects and the cost involved. Myopia is shown to hurt the principal two-fold. If the principal is myopic, she is slow to adjust the contract to binding wages in the future. As a result, any adverse effect on incentives shows up late in the relationship, at an inherently good state, and is permanent. If the agent is myopic, the principal cannot decrease current wages sufficiently to offset the expected slackness in agent's future individual rationality. We also consider an infinite horizon model where current wage binds future wages from below. The dynamic problem is reduced to a series of single-period problems stationary on a properly chosen state space, which allows for computing the model iteratively.