Optimal incentive contracts for knowledge workers

We study optimal incentive provision for "knowledge workers", a crucial resource for many organizations. We augment a standard moral-hazard framework to reflect two key patterns: First, retention is a challenge because workers are free to leave; thereby harming their employer. Second, the value of the worker's outside option might depend on effort on the job. Optimal contracts that retain workers exhibit properties such as first-best effort and surplus, or non-responsiveness to changes in underlying conditions. Due to large rents, full retention is, however, costly for employers. Hence, even when socially inefficient, separation might occur in equilibrium. (c) 2014 Elsevier B.V. All rights reserved.