New SSE/Wharton study on the economics of an investment banking career

Jobs differ widely in the contract terms they offer in terms of salary, job security, work hours, and promotion possibilities. As an example, think about the career choices facing a graduating MBA student. At one extreme, he can aim to become an investment banker,
where pay is quite high, especially in case of promotion. On the other hand, job security is very low, and the initial years are characterized by 100 hour work weeks, many of which are spent on tasks that well-trained secretaries probably could do as efficiently (gathering data,
and preparing spreadsheets and power-point presentations). At the other extreme, he can try to get a work in the finance department of an industrial company, working fewer hours, and having much greater job security, albeit at a lower salary.

If given offers from both types of firms, most MBAs chose the investment banking job despite the gruelling stress and work hours involved. In fact, casual observation suggests that tough work conditions are strongly correlated with attractiveness of jobs. And for good
reason. In an intriguing paper, Paul Oyer (forthcoming) has shown that the MBA student who ends up being lucky enough to get a Wall Street job has an expected lifetime income that is $1.5 million to $5 million higher in present value terms than an equally skilled student
who does not. He finds it hard to explain this with extra cost of effort, so it appears to be a real utility gain. This suggests that the initial job allocation is more than just "assortative
matching" where more talented workers get assigned to more important jobs and get paid their outside opportunity. Instead, there is an element of lottery where the lucky ones get the big prize on Wall Street.

On top of this, it seems like the initial lottery has life-long effects on careers and lifetime earnings. Oyer shows that if a student is unsuccessful in getting hired to a Wall Street job
when he graduates because of bad market conditions rather than lack of interest or lack of ability (for example because it happens to be a down year for Wall Street), he is very unlikely to be able to pursue an investment banking career in later years, even if Wall Street
happens to be booming. The effect on lifetime income appears to be too big to be explained by switching costs for the worker. Instead, it seems to simply be hard to enter high-profile sectors unless you do it very early in your career.

This is a more general labor-market phenomenon. Older workers who lose their jobs because of economic contraction in their industry face much worse prospects than young workers, even if the young workers have less experience and talent. In a sense, there is a "stigma of failure" in the labor market that seems to result from bad luck rather than bad
characteristics or low effort. There is also a related "stigma of success" — a person who has reached a certain position within one industry or company often gets rejected if he applies for
a lower-level position in another firm or industry on the grounds that he is "overqualified".

We try to explain all of the features above within a very natural labor market model where differences in moral hazard problems across industries is a key ingredient. We show that industries where moral hazard problems are bigger are more attractive to workers,
because they typically have to be paid more than their reservation utility to behave properly. In general equilibrium, this is a relative statement — for higher-than-average moral hazard industries, the incentive constraint rather than the participation constraint binds, while the opposite is true for lower-than-average moral hazard industries. The extent to which the incentive constraint is binding will explain the contract terms, promotion structures, firing rates, and composition of work force that an industry uses.

Although the jobs in the highest moral hazard industries are always (at least weakly) more attractive to workers in utility terms, employers will use every possible tool to reduce worker rents. The higher the rents, the more the tools will be used. This explains why attractive
jobs with high salaries tend to have contract terms that —with the exception of the expected salary— are unappealing to workers, including long hours, and high risk of firing. Also, wage schedules tend to be very steep in the high moral hazard industries. It is better to reward employees late rather than early in their careers, because this increases the incentives to work hard for promotion. Because of the steep wage schedules in high moral hazard industries, the incentive constraint typically stops binding after promotion.

In turn, this means that if the firm has different tasks that need to be performed, it is better to assign the "more important", or higher moral hazard, tasks to promoted workers. The first stages of the career in this high-profile industries will be characterized by very long hours on more menial tasks — "the dog years".
Because high moral hazard industries have a relatively bigger advantage of using dynamic incentives such as threat of firing and promotion schemes, young workers with a longer work life ahead of them will be relatively more attractive to hire for these industries. This explains
why it is very hard to enter high-profile industries late in a career. Also, it explains why workers who get fired from high-profile jobs may not be able to find work at a lower level in the same industry — they are "overqualified" or have "too much experience" (a euphemism
for being too old).

Most of the analysis we perform is without any skill difference across workers. When we introduce skill differences, some surprising results fall out. In particular, assortative matching does not hold - the most skilled workers do not get the best (highest utility) jobs.
This is true if variation of skill is not too big, in which case the effect on productivity of hiring the most skilled worker is not too big. However, the threat of firing has a much smaller bite on the more skilled worker. This is because if he is fired, he will be able to get a job in the best industry for fired workers, a first order effect. In a sense, the skilled worker is "overqualified" or "hard to manage" - he does not respond well to incentives because his outside options are too high.