Academic journal article Review - Federal Reserve Bank of St. Louis

Contract-Theoretic Approaches to Wages and Displacement / Commentary

Academic journal article Review - Federal Reserve Bank of St. Louis

Contract-Theoretic Approaches to Wages and Displacement / Commentary

Article excerpt

Models of moral hazard in labor relationships have proven to be useful in explaining a variety of important macroeconomic phenomena. The existence of involuntary unemployment has been linked to the need to provide incentives for workers to choose high effort (Shapiro and Stiglitz, 1984). Further, since wage levels are important for workers' incentives, adjustment of wages in response to cyclical shocks may be subject to contractual constraints. This may help to explain the low observed variability of average wages relative to employment levels (Danthine and Donaldson, 1990, 1995; Strand, 1992; MacLeod, Malcomson and Gomme, 1994). More recently, contracting problems have been tied to inefficient severance of employment relationships, giving a mechanism whereby business cycle shocks may be magnified and made more persistent (Ramey and Watson, 1997a).

This paper focuses on the contracttheoretic underpinnings of wage adjustment and worker displacement in moral-hazard models of the labor market. We show that contracting imperfections play a key role in determining the fragility of employment relationships in the face of shocks to productivity, as well as influencing the form of worker compensation. Moreover, the responses of aggregate wages and employment to business-cycle shocks are sensitive to the structure of worker/firm contracting. Overall, our study establishes that the particular form of contracting imperfections can have major implications for economic outcomes. This highlights the importance of going beyond the reduced-form analysis of contracting that typifies much of the macroeconomics literature.

Our key assumption throughout is that firms and workers maintain long-term contractual relationships, whereby a particular firm and worker transact repeatedly until their relationship is severed. Within a unified theoretical framework, we consider two types of contracting imperfections in labor relationships. First, relationships may be subject to limited verifiability, whereby external enforcement authorities are unable to compel payments conditioned on the full set of actions chosen by the contracting partners. For example, the authorities may be unable to ascertain whether severance of the relationship was due to the worker's action or the firm's action. Second, desirable contracts may be infeasible due to the worker's limited liquidity, which prevents the worker from making payments to the firm.1

We demonstrate that privately inefficient breakup of relationships may occur in the presence of limited verifiability; that is, limited verifiability leads contracts to befragile. The fundamental idea is that when a negative shock hits, the joint returns to cooperation between the firm and worker may be insufficient to offset the collective inducements to behave dishonestly, so there is no way to specify transfers between the firm and worker that can preserve the relationship. Increased verifiability leads to more robust relationships, more direct punishments for misbehavior, and a wider set of optimal compensation schemes. The worker's relative bargaining position always determines his total compensation, while the particular forms of payment may be influenced by the requirements of contracting. Performance bonding, for example, arises naturally in settings of unrestricted liquidity, but may be circumscribed when the worker is liquidity constrained. Moreover, since the form of compensation is identified by the timing and conditioning of payments, informal notions such as salary may be ambiguous.

Our framework also allows for a more precise analysis of the role of wage premia in solving labor contracting problems. We say that a worker obtains an efficiency wage when, in contract negotiation, the firm and worker must directly weigh reducing the worker's compensation against motivating effort. We demonstrate that, in the absence of liquidity constraints, effort incentives are driven by verifiability, bargaining power, and the state of the matching market, but not by the worker's current period compensation. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.