On the Trade-off between Efficiency in Job Assignment and Turnover: the Role of Break-up Fees∗

Firms often specify break-up fees in their employment contracts where a worker is obligated to compensate the firm if he leaves to take up employment with a competitor. We highlight the role of such break-up fees in the presence of asymmetric information about the worker’s quality between the current employer and the outside labor market. Waldman (1984) argues that if the market attempts to learn the worker’s quality from the firm’s job assignment (or “promotion”) decision, it raises the wage of a promoted worker leading to ineffi ciently few promotions. We argue that break-up fees can mitigate such ineffi ciencies by shielding the worker from the potential raiders. But in the presence of firm-specific matching, break-up fees thwart effi ciency in turnover by muting the market’s incentive to bid for the worker. We characterize the optimal contract and show that the optimality of a break-up fee depends on the relative size of the worker’s expected productivity in the preand post-promotion jobs. It is never optimal to specify a break-up fee if the difference between the worker’s expected productivity levels in the two jobs is suffi ciently large. Otherwise, the optimal contract stipulates a break-up fee even though it may lead to market foreclosure for a better matched raider.