PRODUCTIVITY, CONTRACTING MODES, AND DEVELOPMENT

This paper offers a theoretical explanation for the significant variat ions in labor productivity over time and across countries that past em pirical studies have failed to explain by variations in measurable inp uts alone. We argue that firms employ high-powered incentive contracts to achieve high 'X-efficiency' only when the gains from increased pro ductivity outweigh the informational rents firms must pay to create th e necessary incentives. The market has a tendency to sustain too few i ncentive contracts since they generate pecuniary externalities to work ers that are not internalized by private employers. This tendency dimi nishes with factors that increase the opportunity cost of labor and lo wer the rate at which future incomes are discounted. This helps explai n why technological progress, capital accumulation, financial developm ent, and socio-economic stability tend to be accompanied by institutio nal innovations that compound their direct contributions to productivi ty. Our model implies that under reasonable conditions, wage or produc tion subsidies, increased competition among firms in the labor market, and small doses of protection from foreign competition can improve bo th productivity and welfare.