We interpret workers’ conﬁdence in their own skills as their morale, and investigate the implication of worker overconﬁdence on the ﬁrm’s optimal wage-setting policies. In our model, wage contracts both provide incentives and aﬀect worker morale, by revealing private information of the ﬁrm about worker skills. We provide conditions for the non-diﬀerentiation wage policy to be proﬁt-maximizing. In numerical examples, worker overconﬁdence is a necessary condition for the ﬁrm to prefer no wage diﬀerentiation, so as to preserve some workers’ morale; the non-diﬀerentiation wage policy itself breeds more worker overconﬁdence; ﬁnally, wage compression is more likely when aggregate productivity is low.
Fang, Hanming and Moscarini, Giuseppe, "Moral Hazard" (2003). Cowles Foundation Discussion Papers. 1692.