Insurance within the firm

incentives from the optimal compensation contract should be strongest for workers close to
retirement, whose career concerns are weakest.

Firm characteristics are important as well. The first, direct implication of the model is
that firms with more noisy performance should rely less on incentive schemes and provide
more insurance, a proposition that can be tested by considering the firm-level variance of
performance. A second set of implications relates to size, which is likely to matter for
several reasons. First, larger firms have easier access to financial markets, allowing them
to buffer shocks, which is likely to make them more willing to provide insurance (i.e., to
bear risk). In particular, larger firms have easier access to equity capital and can thus
transfer risk to the market. Second, insofar as larger firms produce multiple goods in
multiple locations with diversified processes (or belong to a conglomerate), they might be
more willing to assume risk. Third, the strength of incentives itself may depend on size. If
output depends on aggregate workers’ effort and it is impossible to disentangle individual
contributions, the incentive mechanism becomes less effective as the number of workers
increases.³² These considerations imply more extensive insurance provisions in larger firms
(i.e., lower b_u and b_υ). However, smaller firms should be characterized by a larger variance
of shocks to output which, according to equation (3), should imply less reliance on incentive
schemes.³³ Moreover, (surviving) small firms tend to show a higher growth rate, which allows
for a more extensive use of career promises with respect to monetary rewards to motivate
workers. In addition, only large firms might be able to implement sophisticated contracts.³⁴
The effect of size may also pick up the fact that small firms can use the threat of dismissal
as a more effective discipline device. This is quite likely, as in Italy firing and hiring rules
are much stricter for large firms. Finally, using a variant of the standard agency model,
Schaefer (1998) shows that the sensitivity of wages to firm performance will be increasing
with firm size if the marginal productivity of effort increases with size more rapidly than

³²This can be mitigated by the presence of strong peer pressure. As Prendergast (1999) points out,
however, there is little empirical evidence that peer pressure circumvents free riding in large production
units.

³³Jovanovic (1982) presents a selection model that delivers a positive association between size and the
variance of the rate of growth in output. Such predictions find widespread empirical support (e.g., Dunne,
Roberts and Samuelson, 1989).

³⁴For example, FIAT (the largest private employer in Italy) initiated profit-sharing in the mid-1980s in
order to motivate workers and implement Japanese-style production strategies.

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