In this paper we develop an asymmetric information model that provides a rationale for the existence of pay-for-performance contracts in the absence of incentive for effort and explainswhen and in which occupations pay-for-performance is more likely to be observed. In our model competition among firms for the best workers forces firm to link pay to performancein order to provide the best workers with a higher expected compensation. Furthermore, themodel predicts among other things and contrary to the moral hazard model, that there is anequilibrium in which workers under contracts with a larger pay-for-performance sensitivity exert less effort than workers under contracts with a smaller pay-for-performance sensitivity.The paper also makes contributions to the theoretical literature on screening games. Itis shown that in a competitive market and under a slightly modified timing than the one proposed by Rothschild and Stiglitz’ (1976) a unique equilibrium exits when a appropriatelychosen equilibrium refinement is used and that the standard result in screening games inmonopolistic settings known as no distortion at the top (see, Laffont and Tirole, 1996) doesnot hold in a competitive market.
JEL classification: J31, J33, D82.
Keywords: Incentive pay, insurance, monitoring, screening, straight salaries