Referral-Based Hiring under Misaligned Financial Incentives

We investigate whether referral-based hiring exacerbates or mitigates control problems. Incentive contracts can be used to attract employees with certain traits. However, whether the outcomes are positive for the firm or not depends on the quality of incentive contracts. Our research setting enables us to distinguish between referred and non-referred employees. It also features an incentive contract that rewards two performance dimensions, production efficiency and quality. First, we document that compensation is more sensitive to production efficiency than to production quality. We also show that distorted efficiency-quality tradeoffs (i.e., achieving production efficiency at the expense of production quality) occur under this incentive design. We find that these tradeoffs are exacerbated for referred employees compared with non-referred employees. Our evidence suggests that when incentive contracts do not fully align the interests of employees and the firm, referral-based hiring can exacerbate rather than mitigate the misalignment