How Does Flexible Incentive Pay Affect Wage Rigidity?

Perhaps not as much as you might think:

We introduce dynamic incentive contracts into a model of inflation and unemployment dynamics. Our main result is that wage cyclicality from incentives neither affects the slope of the Phillips curve for prices nor dampens unemployment dynamics. The impulse response of unemployment in economies with flexible, procyclical incentive pay is first-order equivalent to that of economies with rigid wages. Likewise, the slope of the Phillips curve is the same in both economies. This equivalence is due to effort fluctuations, which render effective marginal costs rigid even if wages are flexible. Our calibrated model suggests that 46% of the wage cyclicality in the data arises from incentives, with the remainder attributable to bargaining and outside options. A standard model without incentives calibrated to weakly procyclical wages matches the impulse response of unemployment in our incentive pay model calibrated to strongly procyclical wages.

That is from a new and interesting paper by Meghana Gaur, John Grigsby, Jonathon Hazell, and Abdoulaye Ndiaye.  My take is that effort is often relatively fixed with personality and temperament, and thus more net flexibility results than this paper indicates.  Nonetheless this is an interesting result worthy of some pondering.


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