Job Assignments under Moral Hazard - School of Economics and ...

3. In the lower ability range of job h, the expected output of an agent would be higher
in job l than in job h, if he worked as hard as he now does in job h.
What drives the inefficient job assignment? Because output in the higher level job is more
informative about the agent’s effort, the principal can save on costs for implementing a
given level of effort by lowering the promotion threshold relative to the first-best one.
These savings allow the principal to get the agent to exert extra effort, which drives
up expected output (similar to the case in the two-effort model where the principal
implements low effort in job l and high effort in job h).
3.2.3 Inefficient job assignments and the Peter Principle
Inefficiencies in promotion policies are often attributed to the Peter Principle. It says
that some employees are promoted to their “level of incompetence” and then remain at
that hierarchy level (Peter and Hull 1969). So it refers broadly to cases where, because
of his “incompetence” an employee produces less for the same inputs after a promotion
than he would be capable of producing in his former job.
Often, however, the Peter Principle is interpreted in a more restricted sense, as an ob-
served decline in output after a promotion (e.g. Lazear 2004). An important caveat
arising from our analysis is that such a comparison of actual outputs may be a mislead-
ing test for “incompetence”. Previous theoretical treatments of promotion policies and
the Peter Principle have sidestepped this issue by simply assuming that effort does not
vary across hierarchy levels (see Section 1). 11 Indeed, Proposition 3 shows that output
may rise, simply because a promoted agent works harder – hiding the fact that he is
actually less talented for his new job than he is for his former job.
To capture the possibility that a promoted agent works harder or less hard than he would
if he were reassigned to the previous job, we therefore propose an extended definition of
the Peter Principle.
Definition 1 The (extended) Peter Principle holds for an agent with ability θ who is
promoted to job h, in which he exerts effort eh, if fh(eh, θ) < fl(eh, θ).
That is, the Peter Principle is said to hold if the agent produces less after a promotion
than he would be capable of producing in his former job given the same inputs, i.e.,
holding fixed his effort eh at its post-promotion level.
Our setup links the Peter Principle to the cost of providing incentives: the principal
can use a promotion as a tool to reduce implementation costs or to extract more effort
11 Interestingly, Barmby, Eberth, and Ma (2007) recognize this problem in their empirical test of
Lazear’s (2004) model, and attempt to control for differences in incentives across hierarchy levels using
differences in mean income.
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