Department of Economics. University of Melbourne. Melbourne Victoria 3010 Australia

ABSTRACT

We model career design as a recursive contact design problem in an overlapping generations firm. Agents live two periods. In period 1 they may be hired as employees, paid a wage, and produce output. In period 2 they may be promoted to become joint owners (partners) of the firm, producing an output directly, but setting the rules and receiving the residual income. Professional partnerships, such as the traditional law firm, are often organized like this.

Employees are motivated not only by the wage but by the possibility of promotion to the partnership, and the opportunity to set the rules in the next period; the reward structure is thus recursive. The contracts that emerge in this environment are always inefficient. In many circumstances the inefficiency takes the form of "rat-race" contracts that specify very low wages and an inefficiently high level of effort.

This conclusion seems to be robust to a range of variations in the environment.