Research Summary
Research Summary
Wage Policies and Incentives to Invest in Firm-Specific Human Capital (joint with George Baker and Nancy Dean Beaulieu)
Description
The accumulation of firm-specific knowledge improves firm productivity and employee reten-tion, by creating a wedge between what the employee is worth inside and outside the firm. How does the firm create incentives for investment in firm-specific human capital when this invest-ment requires costly employee effort and is not contractible? We examine the optimal linear wage policies that provide such incentives. We obtain the following results in a one-period model with outside alternatives: (1) The firm-specific and general investments can be substitutes in the employees utility function, even if they are not in the cost function. (2) The firm-specific investment jumps discontinuously from zero to a positive level as the wage policy is adjusted. (3) There are three possible regimes. In some environments the firm is stable, in others it is frag-ile, and in others no profitable wage policy exists. We can also explain why human resource de-partments strive to create employee affiliation, even if a feeling of affiliation is not directly pro-ductive. We go on to derive the optimal wage policy in a dynamic framework when the firm can commit to a long-horizon wage policy. However, this full-commitment wage policy is not dy-namically consistent: the firm would like to renege on its commitment to pay high wages in later periods. This research sheds light on how the incentives for and the accumulation of firm-specific knowledge can lead some firms to a virtuous circle of stability and high profits, while others are constantly on the brink of dissolution.