Informal incentive labour contracts and product market competition

This paper studies the dynamic interaction between product market competition and incentives against shirking. In contrast with standard results, efficiency wages paid by each firm can decrease when competition (i.e. the number of firms in the product market) increases. Discretionary bonuses, on the other hand, do not vary with competition. There is an upper threshold for the number of competing firms, however, above which such schemes are no longer sustainable as an equilibrium. Industry profits with bonuses are generally higher than with efficiency wages but, when information regarding firms’ misbehaviour flows at a low rate, a competition range exists for which firms can make a positive profit by only paying efficiency wages.