Incentives and Selection

Performance pay schemes influence not only workers' incentives to exert effort but also the composition of the workforce in terms of skill. Conventional wisdom suggests that steepening incentives should attract higher-skilled workers. However, we show that this is not universally true: under certain conditions, steeper incentives reduce the average skill level of the workforce. We identify sufficient conditions on observables such that a marginal adjustment to the pay scheme improves the skill composition of the workforce. Building on these insights, we determine the optimal adjustment to incentives that enhances performance without compromising worker selection.