Bonus Question: How Does Incentive Pay Affect Unemployment Dynamics?

This paper asks how flexible incentive pay affects unemployment dynamics. Intro- ducing general dynamic incentive contracts into a benchmark labor search model yields three results. First, the response of unemployment to labor demand shocks is first-order equivalent in an economy with flexible incentive pay and without bargaining, and in an economy with rigid real wages as in Hall (2005)—if both economies are calibrated to the same steady state labor share. Second, with both bargaining and incentives, wage cyclicality arising from bargaining dampens unemployment fluctuations, but wage cyclicality due to incentive provision does not. Third, calibrating the model suggests at least 40% of new hire wage cyclicality in the data arises from incentives. There- fore a standard labor search model, calibrated to weakly pro-cyclical wages, matches unemployment dynamics in our incentive pay model, calibrated to substantially more pro-cyclical wages.