Incentive Contracts and the Allocation of Talent

This article develops a theory of sorting that links ability, pay-performance sensitivity and pay levels. Firms employ managers to improve productivity. Because of limited liability, firms use incentive contracts to elicit managerial effort; the type of optimal contract depends on a manager's ability. In equilibrium, individuals are sorted based on ability into production workers, business owners, managers paid an ability-invariant bonus, and managers whose pay varies with ability and firm size. The model generates predictions regarding the effects of technological progress and product competition on the distributions of wages, pay structure and employment across a wide range of managerial levels.