Productivity, contracting modes, and development

This paper offers a theoretical explanation for the significant variations in labor productivity over time and across countries that past empirical studies have failed to explain by variations in measurable inputs alone. We argue that firms employ high-powered incentive contracts to achieve high 'X-efficiency' only when the gains from increased productivity outweigh the informational rents firms must pay to create the necessary incentives. The market has a tendency to sustain too few incentive contracts since they generate pecuniary externalities to workers that are not internalized by private employers. This tendency diminishes with factors that increase the opportunity cost of labor and lower the rate at which future incomes are discounted. This helps explain why technological progress, capital accumulation, financial development, and socio-economic stability tend to be accompanied by institutional innovations that compound their direct contributions to productivity. Our model implies that under reasonable conditions, wage or production subsidies, increased competition among firms in the labor market, and small doses of protection from foreign competition can improve both productivity and welfare.