In standard shirking models of efficiency wages, workers are motivated only by high wages. Yet 23% of young US workers report receiving some form of performance pay. This paper extends the efficiency wage framework using the theory of self-enforcing agreements to allow for performance pay in the form of bonuses. The result is a simple model of wage formation that helps explain a number of apparently unrelated phenomena in labor markets. First, in efficient markets performance pay is preferred to an efficiency wage when the cost of having a job vacant is low and qualified workers are in short supply. Second, more capital intensive industries offer higher pay than less capital intensive industries, as observed in studies of inter-industry wages differentials. Third, sustaining an efficient outcome requires a social convention similar to the notion of a fair wage, although the outcome itself is determined by fundamentals and not by exogenously imposed notions of what is fair. Finally, a two-sector version of the model makes some predictions about the relationships between turnover and wages and between wages, growth and unemployment.
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