We develop an optimal dynamic contracting theory of overpay for jobs in which moral hazard is a key concern, such as investment banking. Overpaying jobs feature up-or-out contracts and long work hours, yet give more utility to workers than their outside option dictates. Labor markets feature “dynamic segregation,” where some workers are put on fast-track careers in overpaying jobs and others have no chance of entering the overpaying segment. Entering the labor market in bad economic times has life-long negative implications for a worker’s career both in terms of job placement and contract terms. Moral hazard problems are exacerbated in good economic times, which leads to countercyclical productivity. Finally, workers whose talent would be more valuable elsewhere can be lured into overpaying jobs, while the most talented workers might be unable to land these jobs because they are “too hard to manage”.
Financial Markets Group Discussion Papers DP 690