Performance-related pay, efficiency wages and the shape of the tenure-earnings profile

Whilst it is well known that performance-related pay (PRP) may increase wage inequality within a firm, there is an inter-temporal lifecycle aspect that has been largely ignored in the literature. In this paper, we investigate theoretically how the introduction of PRP will influence the wage and remuneration profile over time. We develop a simple two-period model of efficiency wages that rationalizes recent empirical findings suggesting PRP flattens the pay-tenure profile. Such attenuation has important implications for the credibility of long-term employment contracts as it suggests that agency rather than human capital considerations drive the profile.