Delegated Contracting, Wage Compression, and Quiet Quitting

We argue that delegated contracting and transfer pricing can form a set of conditions leading to coarse pay incentives. The allocation mechanism of negotiated transfer pricing creates asymmetry in the intrafirm valuation of employee effort. For a divisional manager, the value of effort is determined by the transfer price but for the center by the contribution to firm profits with the transfer price coming as a cost. Divisional managers’ incentives become misaligned with firm profit maximization, which has implications for employees’ compensation. We demonstrate the optimality of payroll cost controls imposed on divisional managers despite that managers respond by compressing employees’ wages and that employees respond by quiet quitting. We also consider an extension of the model where negotiated transfer pricing can create more distortion in larger firms. Differences in managerial incentives across small and large firms produce the firm-size wage effects: a higher average wage but less wage variation in larger firms.