IMPLICIT CONTRACTS AND FIXED PRICE EQUILIBRIA 5 ment does not carry over to implicit contracts because of the very separation between wages and the marginal revenue product of labor. A complete theory of unemployment must explain why layoffs are preferred to work sharing in adverse states of nature and why laid-off workers are worse off than their employed colleagues. This is not a simple task. Suppose for instance that employers are risk-neutral and that workers' preferences over consumption and leisure can be represented by a strictly quasi-concave, additively separable utility function. Then optimum contracts will result in complete work-sharing [Mortensen, 1978; and if such work-sharing s less profitable than layoffs for technological reasons(e.g, workers produce most efficiently when they put in a full-day' s effort), an op timum contract under perfect information will still equate th workers' marginal utility of consumption in states of employment and unemployment. Individuals may thus voluntarily ei ployed they would rather be laid off than work The resolution of this quandary has been the objective of much recent research on the theory of implicit contracts. The papers of this symposium represent a good step forward, but as we shall see later many questions remain unresolved. To explain unemployment, we need to complicate the analysis in some important way. Some of the complications arise from familiar problems in explicit(as opposed to implicit) insurance contracts, but a few of the problems are peculiar to implicit contracts One distortion that was noted early in the implicit contract lit erature concerns the role of the dole. In very adverse states of nature the flow of insurance indemnities to workers can become a substantial drain on profit; one way to staunch losses is to place the burden of insurance on an outside party, the dole(see Figure I). The practice of layoffs is simply the administrative counterpart of this insur ance-shifting maneuver; workers consent in advance that some of them may be separated from their jobs in order to become eligible for unemployment insurance (UI)payments from an outside public agency. Furthermore, no worker will contract his labor, unless the expected value (utility) of the total package taken over all possible states of nature exceeds the value of being on the dole in every state This means, in turn, that employed workers receive a wage in excess of Ui payments, and are therefore to be envied by their laid- off col- leagues-a situation that many economists would call"involuntary unemployment” This particular insurance contract between a third party(the government)and the other two parties(workers, firmsis not neces-
IMPLICIT CONTRACTS AND FIXED PRICE EQUILIBRIA 5 ment does not carry over to implicit contracts because of the very separation between wages and the marginal revenue product of labor. A complete theory of unemployment must explain why layoffs are preferred to work sharing in adverse states of nature, and why laid-off workers are worse off than their employed colleagues. This is not a simple task. Suppose, for instance, that employers are risk-neutral and that workers' preferences over consumption and leisure can be represented by a strictly quasi-concave, additively separable utility function. Then optimum contracts will result in complete work-sharing [Mortensen, 19781;and if such work-sharing is less profitable than layoffs for technological reasons (e.g., workers produce most efficiently when they put in a full-day's effort), an optimum contract under perfect information will still equate the workers' marginal utility of consumption in states of employment and unemployment. Individuals may thus become involuntarily employed: they would rather be laid off than work. The resolution of this quandary has been the objective of much recent research on the theory of implicit contracts. The papers of this symposium represent a good step forward, but as we shall see later, many questions remain unresolved. To explain unemployment, we need to complicate the analysis in some important way. Some of the complications arise from familiar problems in explicit (as opposed to implicit) insurance contracts, but a few of the problems are peculiar to implicit contracts. One distortion that was noted early in the implicit contract literature concerns the role of the dole. In very adverse states of nature, the flow of insurance indemnities to workers can become a substantial drain on profit; one way to staunch losses is to place the burden of insurance on an outside party, the dole (see Figure I). The practice of layoffs is simply the administrative counterpart of this insurance-shifting maneuver; workers consent in advance that some of them may be separated from their jobs in order to become eligible for unemployment insurance (UI) payments from an outside public agency. Furthermore, no worker will contract his labor, unless the expected value (utility) of the total package taken over all possible states of nature exceeds the value of being on the dole in every state. This means, in turn, that employed workers receive a wage in excess of UI payments, and are therefore to be envied by their laid-off colleagues-a situation that many economists would call "involuntary unemployment." This particular insurance contract between a third party (the government) and the other two parties (workers, firms) is not neces-
QUARTERLY JOURNAL OF ECONOMICS sarily efficient. It may, however, be the only feasible way of providing third- party insurance; theoretically it is preferable that the govern idemnity to the firm when its profit is loy to the worker when his income is low. The government, however cannot always ascertain with precision the actual income or the op- portunity sets of individuals; what it insures, therefore, is not an ex ogenous event but an endogenous variable that is more readily ob servable, and that, under reasonable circumstances, is correlated with the exogenous event. This creates an important moral hazard prob lem 10 to which we shall return in Sections Iv and v nother source of problems for implicit contracts--which applies as well to the insurance literature but has even more force here- the enforceability of contracts. Implicit contracts are just that- mplicit--and one must ask what happens when either side deviates from the contract. Because the contracts are implicit, contracting parties may not have any legal recourse against breach Contracts lust thus either be self-enforcing or be enforced through tions To put the issue in plainer terms, let us focus on the worker: If his wage on average equals his marginal revenue product, what is to stop him from quitting in the good states, when his marginal revenue product is greater than his wage? The worker would thereby receive the benefits of the insurance offered by the firm (when the wage re ceived exceeds the value of his marginal revenue product), and would refuse to pay the insurance premiums. What is to stop him from reneging on his"“ implicit”’ contract? One early answer focused on the role of reputation: workers on contract might choose to reject outside offers at higher wages if, by doing so, they established a reputation for"reliability?"that would enable them subsequently to attract the preferential contracts handed out to“ reliable” workers The precise manner in which one acquires a particular reputation is rather hard to analyze Fortunately, we do not have to, for reputa tion is essential to the enforceability of implicit labor contracts only within the artificial confines of single-period contracts. Bengt Holmstrom demonstrates the point admirably in his paper"Equi librium Long- Term Labor Contracts"this ournal Holmstrom al lows workers to sign multiperiod contracts that they can abrogate at no cost after one period if they find a higher-paying job in the spot 10. A standard early reference on moral hazard is Arrow (1971 for a more recent Grossman (1977 was among the first to point out this problem
6 QCARTERLY JOURNAL OF ECONOMICS sarily efficient. It may, however, be the only feasible way of providing third-party insurance; theoretically it is preferable that the government pay a lump sum indemnity to the firm when its profit is low, or to the worker when his income is low. The government, however, cannot always ascertain with precision the actual income or the opportunity sets of individuals; what it insures, therefore, is not an exogenous event but an endogenous variable that is more readily observable, and that, under reasonable circumstances, is correlated with the exogenous event. This creates an important moral hazard problemlo to which we shall return in Sections IV and V. Another source of problems for implicit contracts-which applies as well to the insurance literature but has even more force here-is the enforceability of contracts. Implicit contracts are just thatimplicit-and one must ask what happens when either side deviates from the contract. Because the contracts are implicit, contracting parties may not have any legal recourse against breach. Contracts must thus either be self-enforcing or be enforced through reputations. To put the issue in plainer terms, let us focus on the worker: If his wage on average equals his marginal revenue product, what is to stop him from quitting in the good states, when his marginal revenue product is greater than his wage? The worker would thereby receive the benefits of the insurance offered by the firm (when the wage received exceeds the value of his marginal revenue product), and would refuse to pay the insurance premiums. What is to stop him from reneging on his "implicit" contract? One early answer focused on the role of reputation: workers on contract might choose to reject outside offers at higher wages if, by doing so, they established a reputation for "reliability" that would enable them subsequently to attract the preferential contracts handed out to "reliable" workers. The precise manner in which one acquires a particular reputation is rather hard to analyze. Fortunately, we do not have to, for reputation is essential to the enforceability of implicit labor contracts only within the artificial confines of single-period contracts. Bengt Holmstrom demonstrates the point admirably in his paper "Equilibrium Long-Term Labor Contracts" [this Journal].Holmstrom allows workers to sign multiperiod contracts that they can abrogate at no cost after one period if they find a higher-paying job in the spot 10. A standard early reference on moral hazard is Arrow jl97lJ:tor a more recent treatment see Arnott and Stiglitz 11982). 11. H. Grossman [I9771 was among the first to point out this problem
IMPLICIT CONTRACTS AND FIXED PRICE EQUILIBRIA 7 market. Nevertheless, equilibrium contracts will be structured so that workers choose not to annul them: wages in the first period, when workers cannot leave are lower than(the expected value of) MRPL in the second period wages rise to equal either a state-invariant rate or the spot rate, whichey New workers on contract thus pay the firm a"bond"that assures they will behave reliably in the future. As the bond is amortized over time, veteran employees receive higher wages than rookies do--at least as high, in fact, as spot wages. Holmstrom's multiperiod equi librium thus yields reliable behavior on the part of workers(his firms being reliable by definition), wage differentials by seniority class, and a weakening of strict wage rigidity to downward rigidity Holmstrom's argument parallels the standard argument as to how the firm recovers the costs of specific training of workers. 12If workers have limited access to the capital market, increased mobility implies that their consumption stream over time is not so smooth as it otherwise would be and there is a welfare loss as a result in addi tion, however, workers may need to leave the firm for a variety of good reasons(their health is bad, their mother- in-law moves to a nearby state, etc.) Unfortunately, there is no easy way of distinguishing these le- gitimate motives for quitting from the opportunistic motives (i.e simply reneging on the contract). Hence any contract that requires workers to post bonds imposes some risk on them-the risk that they forfeit the bond even if they desire to change jobs for noneconomic reasons. As a result, there will seldom be"complete"bonding. Finally there is always another risk associated with any theory of contract enforcement through bonding: that the employer will fire the worke (or, equivalently, make work conditions so unattractive that the worker will be induced to quit and forfeit the bond). 13 To avoid these difficulties, either a far more complicated bonding scheme must be established, or we must rely on a theory of reputation for firms Let us return to a simpler world in which firms are thoroughly trustworthy and workers never quit for family reasons. Having at least assured ourselves that we can redesign the time path of wage pay ments to extract reliable behavior from workers, we go back to the single-period enforceable contract structure of Figure I to reflect on
IMPLICIT CONTRACTS AND FIXED PRICE EQUILIBRIA 7 market. Nevertheless, equilibrium contracts will be structured so that workers choose not to annul them: wages in the first period, when workers cannot leave, are lower than (the expected value of) MRPL; in the second period wages rise to equal either a state-invariant rate or the spot rate, whichever is greater. New workers on contract thus pay the firm a "bond" that assures they will behave reliably in the future. As the bond is amortized over time, veteran employees receive higher wages than rookies do-at least as high, in fact, as spot wages. Holmstrom's multiperiod equilibrium thus yields reliable behavior on the part of workers (his firms being reliable by definition), wage differentials by seniority class, and a weakening of strict wage rigidity to downward rigidity. Holmstrom's argument parallels the standard argument as to how the firm recovers the costs of specific training of workers.12 If workers hhve limited access to the capital market, increased mobility implies that their consumption stream over time is not so smooth as it otherwise would be, and there is a welfare loss as a result. In addition, however, workers may need to leave the firm for a variety of good reasons (their health is bad, their mother-in-law moves to a nearby state, etc.). Unfortunately, there is no easy way of distinguishing these legitimate motives for quitting from the opportunistic motives (i.e., simply reneging on the contract). Hence, any contract that requires workers to post bonds imposes some risk on them-the risk that they forfeit the bond even if they desire to change jobs for noneconomic reasons. As a result, there will seldom be "complete" bonding. Finally, there is always another risk associated with any theory of contract enforcement through bonding: that the employer will fire the worker (or, equivalently, make work conditions so unattractive that the worker will be induced to quit and forfeit the bond).13 To avoid these difficulties, either a far more complicated bonding scheme must be established, or we must rely on a theory of reputation for firms. Let us return to a simpler world in which firms are thoroughly trustworthy and workers never quit for family reasons. Having at least reassured ourselves that we can redesign the time path of wage payments to extract reliable behavior from workers, we go back to the single-period enforceable contract structure of Figure I to reflect on 12. A more extensive treatment appears in Arnott and Stiglitz 11981J. 13. See Shapiro and Stiglitz [I9821 for a detailed discussion of this problem