Differentiation and Risk Aversion in Imperfectly Competitive Labor Markets

We examine the effect of imperfect labor market competition on the efficiency of compensation schemes in a setting with moral hazard and risk-averse agents who have private information on their ability. Two heterogeneous firms compete for agents by offering contracts with fixed and variable payments. When competition is low, low-ability agents are underincentivized, exerting too little effort. When competition is high, high-ability agents are overincentivized and bear too much risk. For intermediate competition, contracts are second-best. An equilibrium where both firms are active exists only when the least-cost separating allocation is interim efficient.