Managing intrinsic motivation in a long-run relationship

We study a repeated principal-agent interaction, in which the principal offers a ”spot” wage contract at every period, and the agent's outside option follows a Markov process with i.i.d shocks. If the agent rejects an offer, the two parties are permanently separated. At any period during the relationship, the agent is productive as long as his wage does not fall below a ”reference point”, which is defined as his lagged-expected wage in that period. We characterize the game's unique Markov perfect equilibrium. The equilibrium path exhibits an aspect of wage rigidity. The agent's total discounted rent is equal to the maximal shock value.