Abstract
The goal of this study is to relate and jointly explain the empirical regularities of the compression of ratings and .rm-size e¤ects on wages. We develop a three-tier model of a .rm.s economic organization, which is centered on the empirical observation that managers face a soft budget constraint when evaluating their employees.performance. The model assumes that in small .rms managers are held more accountable for payroll expense incurred than they are in large .rms (because of lesser informational asymmetries). Incorporating these features into an otherwise standard agency model, this study predicts di¤erences in pay schedules between small and large .rms of the kind that is empirically observed. In particular, we argue that the large-.rm wage premium and inverse relationship between wage dispersion and .rm size can be the optimal outcomes of the agency problem with unaccountable managers that is studied here. The model also shows that the compression of ratings in job performance appraisals can be an equilibrium outcome.