Pareto Gains from Limiting Compensation Options

We examine the effects of a single payment structure policy (SPP) that prevents an employer from offering an employee a choice among compensation structures. An SPP reduces the employer's profit and increases the employee's welfare when the employee's (privately known) ability is exogenous. In contrast, an SPP can increase both the employer's profit and the employee's welfare when the employee's ability is endogenous. An SPP secures these Pareto gains by restricting the employer's ability to limit the rent the employee earns from high ability, thereby inducing the employee to increase his human capital investment.