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

in the hierarchy often put low demands in terms of the inputs ability and effort. Hence,
in the low ability job success might be quite likely even without hard work (i.e., it is is
a relatively easy task). In the high ability job, if the agent does not work hard, there
is a bigger drop in expected output (i.e., it is a more difficult task for him). Seeing
such an agent succeed in what is for him a difficult job, thus, indicates that he must
have worked hard. So the high ability job poses a harder test of the agent’s effort than
the low ability job, and this makes it less costly to get the agent to exert effort. That
output in the higher level job is often more informative about the agent’s effort than
output in the lower level job is a view also found in the literature (Baker, Gibbons,
and Murphy 1994, Maskin, Qian, and Xu 2000, Ortega 2003). As we show, the reduced
cost of incentives (due to differences in informativeness about effort across hierarchy
levels) outweighs the negative effect of a lower success probability near the ability cutoff
level for efficient job assignment. Hence, the principal sets a lower ability threshold for
assignment to the more informative higher hierarchy level than is efficient.
The mechanism at work is a static one: the job assignment decision in one period affects
the contemporaneous cost of providing incentives. This static mechanism on its own
offers several new insights into the driving forces governing promotion decisions in firms.
Embedding our model in a stylized dynamic framework and extending it to allow for
continuous effort, we show that it may be optimal for a firm to promote an employee to
a higher level job even though it knows that he will be less productive than he could be
in his previously held position. This finding provides a new perspective on possible roots
of the Peter Principle: even in ideal circumstances where a firm is perfectly aware of its
employees’ abilities one may find employees in jobs for which they are not well suited.
Our analysis highlights that promoting an employee to a job for which he is less com-
petent need not lead to an observed decline in output – a narrow definition of the Peter
Principle often used in the literature (e.g. Lazear 2004). Output may actually rise be-
cause the promoted agent works harder – hiding the fact that he actually is untalented
for his new job. Existing theoretical treatments of promotions in firms have ignored
this effect of job assignments on implemented effort levels: they either abstract from
incentives altogether or assume that effort is constant across hierarchy levels. This effect
may, however, be an important driving force for promotion decisions, as our analysis
shows. We therefore suggest an extended definition of the Peter Principle that includes
both the possibility that a promoted agent works harder or less hard than he would if
he were reassigned to the previous job. Our setting with varying effort levels across hi-
erarchical levels allows to show that an employee moving up the career ladder may earn
more and produce more only because he has to work harder than he would in his old job.
The paper is organized as follows. Next we discuss the related literature. Section 2
3