Avoiding the Cost of a Bad Hire: On the Optimality of Pay to Quit Programs

Avoiding the Cost of a Bad Hire: On the Optimality of Pay to Quit Programs

November 18,2017Working Paper No. 3614

Contracts that compensate workers if they choose to leave an organization - or Pay to Quit programs - are becoming increasingly prevalent in both established and new companies. In this paper, we address the puzzle of why such employment contracts are offered. We propose a model to study the optimal employment contract when firms face both an adverse selection problem - they need to find a good fit for the project - and a moral hazard problem - they need to incentize employee effort. Moreover, hiring the bad fit is costly for the firm because taking on a worker requires the firm to relinquish an outside option, coming for instance form being able to search for a new candidate. We fully characterize the optimal employment contract in this environment and derive the conditions under which offering a payment for quitting is optimal.