Description:
We study an infinitely repeated principal-agent relationship with on-the-job search. On-the-job search is modeled as a dimension of the agent's effort vector that has no effect on output, but raises his future outside option. The agent's incentives to search are increasing in the degree to which a higher outside option improves his gains from trade. Search also increases the agent's cost of effort thus generating an effort-substitution problem between work and search effort. We show that the principal can mute search incentives by offering an efficiency wage contract. Due to effort substitution, efficiency wages increase the agent's work effort incentives for a given bonus scheme. Thus, efficiency wages serve as a complement rather than as a substitute to piece rates. Our results provide a new rationale for the use of efficiency wages as an incentive device and hence greatly extend the set of environments in which efficiency wages are predicted to be useful as an incentive device. Our findings thus also contribute to the explanation of empirically observed inter-industry variation in the size and composition of worker compensation.