Making the Right Assignment: Optimal Contracting for Post-Hire Selection

We study the contracting problem of a principal who chooses between motivating an agent to exert effort or taking her outside option. The agent is privately informed about his ability, where a higher-ability agent faces a lower cost of exerting effort. We show that, when the principal’s outside option is sufficiently large, she wants to exclude low ability agents while motivating high-ability agents to provide effort. To do so, the optimal contract offers a fixed salary to the agent who does not work on the project, and a compensation contingent on output for the agent who does. Furthermore, when the outside option of the principal is moderate, the optimal contract offers both a compensation contingent on output and a probability of being excluded from the project, and may feature a fixed salary as well. The model rationalizes the practice among companies of internally selecting employees into either high impact or low impact project units or career tracks, and provides a complete characterization of how this selection should be done.