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文/Ann-Sophie Vandenberghe

LABOR CONTRACTS

Ann-Sophie Vandenberghe

Netherlands School for Social and Economic Policy Research

Utrecht University

© Copyright 1999 Ann-Sophie Vandenberghe

 

Abstract

This chapter contains an overview of the literature on labor contracts. Four

important aspects of the employment relationship will be discussed:

matching of employer and employee, acquisition and retention of firmspecific

human capital, earnings stability as insurance and the effort

intensity of employees. These four important areas of the employment

relationship are encountered by imperfections, mainly information problems

and opportunistic behavior. Some labor market institutions, such as the

design of a certain wage policy, can be explained as devices to overcome

these imperfections.

 

The employment contract can be viewed as a combination of explicit and

implicit agreements. An explicit contract is legally enforceable. An implicit

contract is an informal understanding which is too vague to be legally

enforceable. In order to be of any value, the implicit contract must be selfenforcing.

JEL classification: J41, K31

Keywords: Adverse Selection, Asymmetric Information, Efficiency Wage,

Effort, Firm Specific Human Capital, Implicit Contracts, Opportunistic

Behavior, Signaling

 

1. Introduction

Job matching constitutes the process whereby heterogeneous workers are

matched to heterogeneous jobs. This matching process consists of two steps:

discovering appropriate individuals and providing the workers with specific

skills (see Elliott, 1991, p. 292). The first step is to discover appropriate

individuals and will be discussed in Section 2. The employer wants to find

the ‘right’ kind of employee and the employee wants to find the ‘right’ kind

of job. Information asymmetry and opportunistic behavior of one or both

parties at the precontractual stage might result in a suboptimal match and in

adverse selection. Some devices help parties to overcome those

inefficiencies.

 

In Section 3, the second step of the matching process or the investments

in specific human capital by both employer and employee are considered.

These investments are specific to the unique match between a firm and the

worker and will be lost if the match is broken (see Becker, 1975; Parsons,

1986, p. 819). Therefore, compensation schemes might be adopted to

prevent the employee from quitting soon after investments are made. Parties

might also behave opportunistically as regards the division of the surplus

resulting from investments in firm-specific training. Parties who anticipate

the opportunistic behavior might refrain from investing in specific capital;

this is the hold up problem. One role of the employment contract is to

overcome the hold up problem by introducing wage rigidity.

 

Another role of the employment contract, as will be shown in Section 4,

is to enable firms to share the risks for uncertain income streams. This is at

the heart of the implicit contract theory which also provides arguments for

wage rigidity. In Section 5 an overview is given of the employment arrangements,

mainly compensation plans, used to induce an employee to provide

the optimal level of effort.

 

Finally, some characteristics of the form of the employment contract will

be explained; the employment contract is in general a long-term, incomplete

and self-enforcing implicit contract.

 

2. Matching of Employer and Employee

 

For markets to successfully promote mutually beneficial transactions, both

buyers and sellers must have access to accurate information about the quality

and price of the goods (Ehrenberg and Smith, 1997, p. 378). Translated to

the labor market the employer wants to have information about the

productivity level of the potential employee and his attachment to the job;

the employee wants to have information about the pecuniary and non

pecuniary job characteristics. Schäfer and Ott (1993) and De Geest (1994,

pp. 167-189) summarize the law and economics literature on information

production in the precontractual stage in general. De Geest, et al. (1999)

apply the insights of the general analysis of information production to labor

contract negotiations.

 

In many cases the information is ‘asymmetric’ - that is, when one party

knows more than the other about its intentions or performance under the

contract. When information is asymmetric, opportunities for malpractice are

enhanced. Applicants have incentives to overstate their productive capacities

and employers have incentives to represent jobs as less demanding than they

may actually be. As a result, mutually beneficial transactions may be

‘blocked’ and disallocation of the resource labour may be the result.

It is interesting to look at some labor market institutions that remove the

information asymmetry or reduce the inefficient consequences of it, on the

employer’s side as well as on the employee’s side.

 

Employer’s Side

It is profitable for an employer to distinguish between high-productivity

workers and low-productivity workers. How can the employer find out about

a potential employee’s productivity? A mechanism by which employers and

employees deal with the problem of asymmetric information is ‘signaling’.

The concept of job market signaling was first developed by Spence (1973).

He uses the term signals for those observable characteristics attached to the

individual that are subject to manipulation by him. The costs of making the

adjustments by manipulation are signaling costs. A signal is strong when the

signaling costs are negatively correlated with the individual’s unknown

productivity so that high-productivity persons are more likely to give the

signal than low-productivity persons. Education might be a strong signal in

labor markets.

 

Prior to hiring, the employer not only wants to know the potential

productivity but also whether the employee is likely to stay for a long term

with the employer, especially when firm-specific investments will be made.

Salop and Salop (1976) offer a sorting model of quit behavior. The rationale

is that offered pay plans may induce signaling. Employees who choose to

work under compensation plans with deterred payments, signal that they

intend to stay for a longer time with the employer. ‘The essence of signaling

... is the voluntary revelation of truth about oneself in one’s behavior, not

just one’s statements’ (Ehrenberg and Smith, 1997, p. 379). In many cases

complete information revelation about the potential employee’s productivity

is not possible at a reasonable cost; the information will remain partly

asymmetric which may have inefficient consequences.

 

An important consequence of the asymmetry of information at the

precontractual stage is known as adverse selection. The adverse selection

problem was discussed by Akerlof (1970) in the used car market. In the

employment relationship the adverse selection problem arises when

employers cannot devise a way to distinguish between groups of employee

candidates with different levels of productivity at a reasonable cost. In that

case, firms would be forced to assume that all applicants are ‘average’ and

would pay them an average wage. Low-quality workers would profit as they

are paid a wage above the value of their marginal productivity, where goodquality

workers are underpaid. According to Weiss (1980) this will result in

good-quality workers refraining from applying for the job; employees (as

opposed to employers) know their productivity and will only accept wages

that correspond with their productive endowments. Only the low-quality

workers find it profitable to apply for the job. However, the employer can

attract more high-quality employees by offering a higher wage. ‘Because

reservation wages are positively correlated with labor endowments, if a firm

were to cut the wage it offered, the workers that would be discouraged from

applying to work for the firm would be the workers that the firm finds most

desirable’Weiss, 1991, p. 15). This model is an efficiency-wage model, and

the reason for paying above market wages is to avoid adverse selection; this

will be done by enlarging the pool of applicants with good-quality workers.

 

Discrimination might be another consequence of asymmetric information

when screening and signaling are not perfect. Statistical discrimination

might occur when the employer assigns group characteristics to people who

may not be typical of the group. Employers who rely on false stereotypes will

face adverse selection because they are not hiring the most productive

workers. Chapter 5530 gives an overview of Employment Discrimination.

 

Employee’s Side

We now turn to the information shortage on the side of employees with

respect to the job characteristics. The employer normally possesses more

information about the job characteristics, but he will have the incentive to

present the job as less demanding than it actually is. Economic theory,

however, predicts that compensating wage differentials will be associated

with various job characteristics. Positive differentials (higher wages) will

accompany ‘bad’ characteristics, while negative differentials (lower wages)

will be associated with ‘good’ ones (Ehrenberg and Smith, 1997, p. 251). A

company offering a job with ‘bad’ characteristics with no compensating

wage differentials would have trouble recruiting or retaining workers; the

company would eventually be forced to raise its wages, even above the wage

level offered by the company offering good characteristics. The prediction

that there are compensating wage differentials was already proposed by

Adam Smith in his The Wealth of Nations (1776). The prediction is only

true under the assumption that workers want to maximize their utility, are

informed of the job characteristics and perfect worker mobility (see, for

example, Ehrenberg and Smith, 1997, chapter 8). When the assumptions are

not fulfilled, regulation might discipline the employer. For an overview of

Occupational Safety and Health Regulation see Chapter 5540.

 

3. Firm Specific Investments

 

Many workers increase their productivity by learning new skills and

perfecting old ones while on-the-job. Gary Becker (1975) was the first to

formalize the distinction between two types of on the job training: general

training that increases an individual’s productivity to many employers

equally, and specific training that increases an individual’s productivity only

at the firm in which he or she is currently employed.

 

Future productivity can be improved only at a cost. These investment

costs will only be incurred when there is a possibility to recoup the returns of

investments. This necessitates that the employment relationship should

endure for a sufficiently long period of time. Some arrangements of the

employment relationship can be seen as incentives for the continuance of the

relationship. The original theoretical literature in the area of human capital

theory (Becker, 1975; Mincer, 1962; Oi, 1962; Parsons, 1972; Pencavel,

1972; and Salop, 1973) focused on the effect of firm specific human capital

on firm compensation policies and the consequences for firm lay-off and quit

experiences.

 

General Training

Because general training increases workers’ productivity in the firm

providing it, as well as in many other firms, the prediction holds true that

firms will not offer general training, or only if the employees bear the full

cost of their training. However, general training is widely provided and paid

for by employers in the actual labour market. A possible explanation is that

the mobility of workers to work for another firm is sufficiently limited by the

mobility costs, that is by the various costs employees must naturally bear in

finding other offers and switching employer. In that way employers can

obtain the returns of the training if they have paid for it.

 

Specific Training

Becker (1975) defines ‘completely specific’ training as training that has no

effect on the productivity of trainees that would be useful in other firms. If

training were completely specific, the wage that an employee could get

elsewhere would be independent of the amount of training he had received.

When a firm offers specific training, it has to decide how to structure wages

during and after training so that it can recoup its investment. This will be

explained with the two period example (this is essentially the model

developed in Becker, 1975). Suppose the firm’s workers come to it with a

marginal product of MP*, and they can obtain a wage of W* (=MP*)

elsewhere. If they receive specific training in the first period of employment,

their marginal product with the firm is reduced to MP0 (< MP*) during the

training period but rises to MP1 (>MP*) in the post-training period. The

difference between MP1 and MP* in the post-training period is called the

post-training surplus. What is the optimal pay policy to be adopted by the

firm? First, a firm is hurt by the departure of a trained employee because an

equally profitable new employee could not be obtained and the firm’s

training investments would be lost. Therefore the firm must offer a posttraining

wage that is high enough to discourage its trained workers from

quitting immediately after training (W1 > W*). But the firm incurred costs

in the training period, which it wants to recoup. Therefore the post-training

wage must be below MP1 (W1 < MP1) so that the firm is allowed to recoup

investment costs. Where exactly within this range W1 will be depends on

the mobility costs (job search costs, change of residence) of the trained

employee. If these costs are high, then W1 need not be much above W* to

induce those workers to stay with the firm in the post-training period. When

employees are offered some of the return from training, the higher wage

would make the supply of trainees greater than the demand, and rationing

would be required. The final step is then to shift some training costs as well

as returns to employees. This will be done by offering a wage below W* in

the training period. Some of the training costs will be borne by the employer.

Therefore the wage will be higher than MP0. If employees bore all the costs

of specific training, then employers would have no investment to protect and

would not be inhibited from firing employees after training. The optimal pay

policy is one in which firms do not pay all training costs nor do they collect

all the return, but they rather share both with the employees.

 

In the efficiency-wage theory it is shown that high wages have a quitdeterring

effect (Salop, 1973, 1979; Stiglitz, 1974). So employers pay an

above market wage in order to prevent their specifically trained employees

from quitting. But an element that also plays an important role in efficiency

wage theories is unemployment. The basic idea is that employees are less

likely to quit when their current wage is higher than what they can earn

elsewhere and when the level of unemployment is higher.

 

Hold-Up Problem

Becker focused on the possibility of the employee to threaten in an

opportunistic way to quit after the firm makes the specific investment unless

the wage rate is adjusted upwards. Becker’s solution is a sharing of the costs

and benefits of the specific investment via an initial lump-sum payment by

the employee and a later higher-than-market wage. But as Klein, Crawford

and Alchian (1978) show, this solution does not eliminate the bilateral

opportunistic bargaining problem; the employer may later decrease the wage

back to the competitive level or the employee may demand a higher wage to

appropriate the partial specific investment by the employer. Williamson

(1985) has termed this problem ‘hold-up’. By threatening to quit, an

employee might bargain for a large share of the surplus in a way that the

employer can only partly reap the returns of his specific investment. The

employer will have to concede because if the employee quits, the employer

cannot reap any returns at all. The same is true for the employee who has

invested in specific training when the employer acts strategically by

threatening to dismiss the employee. Parties might anticipate this

opportunistic behavior and refrain from firm-specific investments. The

investments in specific training will then be less than what is socially optimal.

A solution put forward in the literature is a formal fixed-wage

contract specifying a wage at the start of employment (Klein, Crawford and

Alchian, 1978; Macleod and Malcomson, 1993; and Malcomson, 1997).

When renegotiations are avoided through wage rigidity, the scope for

opportunistic behavior will be smaller: ‘a contract that ensures a wage independent

of the amount the firm invests insures those investments are efficient’

(Malcomson, 1997, p. 1933). However, a wage contract will not

completely avoid the hold-up problem, especially when alternative market

opportunities for one or both parties are considered. Due to macro shocks in

product demand and firm-specific shocks, the alternative opportunities for

one or both parties might be better than the existing wage contract. In order

to avoid an inefficient separation, the wage must be adjusted. Those

adjustments are normally not foreseen in the employment contract because

the employment relationship is too complex and uncertain. Renegotiation is

necessary and again the hold-up problem occurs.

 

Renegotiation to prevent an inefficient separation when an outside option

constraint binds may allow one party to capture part of the returns to specific

investments made by the other. Anticipation of that means that the original

investments may not be efficient. (Malcomson, 1997, p. 1943)

 

According to Teulings (1996) the solution is to delegate the power to

renegotiate to centralized labour unions and employer organisations.

Negotiations are then independent of the problems of the workplace and

specific investments do not influence the decisions.

 

In general the fear of opportunistic behavior leads to wage rigidity in

long term explicit contracts where specific human capital is present. This

argument is distinct from the argument for the existence of rigid long-term

implicit labor contracts as a means of bearing risk. The use of the

employment contract as an insurance contract will be discussed in the next

section.

 

4. Insurance Contract

 

Azariadis (1975) considers the risk-neutral firms to act both as employers

and as insurers of homogenous, risk-averse laborers. The use of the

employment contract as an insurance contract has been discussed in the

implicit contract theory. The origins of implicit-contract theory lie in the

belief that observed movements in wages and employment cannot be

adequately explained by a competitive spot labor market in which wages are

always equal to the marginal product of labor and the labor market is always

in equilibrium. Instead, the observation in the labor market is that over the

cycle wages are ‘rigid’ while employment varies. Basic ideas about implicitcontract

models were originally proposed by Baily (1974), Gordon (1974)

and Azariadis (1975). But the ideas spawned an enormous amount of

literature. For surveys see Azariadis and Stiglitz (1983), Hart and

Holmstrom (1986) and Rosen (1994).

 

The earliest literature on implicit contracts exploits the insight by Knight

(1921), who argued that inherently confident and venturesome entrepreneurs

will offer to relieve their employees of some market risks in return for the

right to make allocative decisions. The basic idea of implicit-contract theory

is that in their dealings employers are less risk-averse than workers. One

reason is that owners of capital who represent the employers can divide their

capital among many different firms through the stock market, and by this

diversification they obtain insurance against the risks faced by individual

firms. On the other hand, for workers it is generally difficult to diversify

assets which take the form of human capital because workers generally work

for only one employer at the time.

 

Risk-averse workers do not like fluctuations in their wages. But in a

competitive labor market, fluctuations in the marginal product of labor

would lead to fluctuations in the wage. However, the risk-averse employee is

willing to pay for income certainty because it increases his utility. Due to the

imperfect nature of insurance markets, workers who desire such an insurance

coverage cannot get it on the insurance market. The employing

firm, having more information than a separate insurer, is much better placed

to undertake the insurance function, if compensated for it. The crucial

feature of implicit-contract models is how risk is shared between workers

and firms. Both parties to the employment relationship can be made better

off by replacing a fluctuating wage with a fixed wage contract which has a

slightly lower average value. So it appears that the implicit contract theory

can explain wage stickiness, one of the stylized facts of the labor market. In

the optimal contract, the wage is rigid and does not vary with the marginal

revenue product of labor. The marginal revenue product is supposed to be

high in good times and low in bad times. In that way the employment

contract will include an insurance element, insuring workers against bad

times by collecting premiums from them in good times.

 

According to Azariadis (1987) an implicit contract is a complete

description, made before the state of nature (good or bad) becomes known, of

the labour services to be rendered unto the firm in each state of nature, and

of the corresponding payments to be delivered to the worker. These types of

risk sharing agreements are termed ‘implicit-contracts’ in the implicit

contract theory. By ‘implicit’ we normally mean that something is

understood to be the case. In the case of a contract, an implicit contract has

connotations of an informal arrangement which is not written down. The

converse of an implicit contract would then be an explicit contract in which

everything that matters is clearly specified and written down. The use of the

term ‘implicit contracts’ to denote risk-sharing contracts is rather confusing

according to Bosworth, Dawkins and Stromback (1996, p. 280). It is not the

implicit nature of the insurance contract that is the crucial feature of implicit

contract theory, but it is the question how risk is shared between employer

and employee. For that reason, ‘risk-sharing agreements’ would be a better

term. It is, however, true that the risk-sharing agreement considered by the

implicit contract literature is implicit. Indeed, we do not observe such risksharing

contracts in the real world, so if they exist they must be implicit (see

Manning, 1990, p. 65).

 

The problem with contracts that are implicit (understood) compared to

explicit (written) contracts, is that they are not enforceable by a third party,

such as a court. One of the parties might breach the implicit risk sharing

agreement; the employer can increase his profits by dismissing the worker

whose marginal revenue product is below the fixed wage in the bad state of

nature and replace him by a cheaper worker, and the employee has an

incentive to quit when his marginal revenue product is higher than the fixed

wage in the good state of nature. These implications can be avoided when

the implicit contract is self enforcing through labor market institutions such

as mobility costs (for example Baily, 1974) and reputation (for example

Holmstrom, 1981; and Bull, 1987). The mechanism of self-enforcing

implicit contracts will be further discussed in this contribution.

 

5. Employee’s Effort Level and Compensation Scheme

 

The employment relationship can be thought of as a contract between a

principal (the employer) and an agent (the employee). The employee is hired

to help advance the employer’s objectives in return for receiving wages and

other benefits. But workers are considered to be utility maximizers. They are

primarily motivated by self interest and they seek to avoid unpleasant or

otherwise costly activities. Which policies can employers devise in order to

ensure the alignment of the agent’s interests with those of the principal and

more specifically to induce a high level of effort from their employees?

 

One way to motivate high levels of effort is to closely supervise

employees. According to Alchian and Demsetz (1972), the essence of the

firm is ‘the centralized contractual agent in a team productive process’. And

one method of reducing shirking is for someone to specialize as a monitor to

check the input performance of team members.

 

While virtually all employees work under some form of supervision,

close and detailed supervision or monitoring is costly. With imperfect

monitoring and full employment, workers will choose to shirk, that is to

provide a low level of effort. If supervision or monitoring is too costly, the

employer can use various compensation plans to motivate the employee to

work hard.

 

A possible incentive-based pay scheme to motivate the employees is

linking one’s pay to one’s output. Possible systems under which workers are

paid for their output are piece-rate pay, payment by commission, gainsharing,

profit-sharing, and bonus plans. Although such pay systems reduce

the monitoring costs for the employer, in reality in most employment

relationships employees are paid (at least partly) for their time. Output-based

pay encounters difficulties of measurement of output. Such incentive

contracts that are legally enforceable are limited by the practical difficulty of

finding measures of employee performance that can be verified in court.

Without such verifiability, contracts that make the wage conditional on

output will not be legally enforceable (Macleod and Malcomson, 1987,

1989). Another problem is that a system of pay for performance places

employees at a risk of having earnings that are variable over time. Such a

system does not satisfy the desire of a risk averse employee (see Section 4

above contract) and the employee is only willing to accept the risk if this is

offset by a higher expected income. At the heart of the principal-agent

problem lies the inevitable trade-off between the provision of incentives to

work hard and the sharing of risks. The challenge is to design an

employment contract so that there are incentives to perform well, but

without burdening the workers with too much risk (see for example Douma

and Schreuder, 1998, 7.6).

 

Given the difficulties with output-based pay plans, another method to

increase the chances that the workers will not shirk their duties is to pay

them a wage above the market wage. This method has been the object of the

efficiency-wage theories. The reasons why higher wages are thought to

generate greater productivity from given workers all relate to the commitment

to the firm they build.

 

Wages affect the productivity of individual workers by affecting whether

workers are supportive or antagonistic to their employer. The main

contributor to this line of investigation has been Akerlof (1984) in the

context of ‘gift-exchange’ relationships. He argues that when firms pay

‘high’ wages they are in effect making a gift to the workers, which is

reciprocated by the workers. They act in ways that benefit the firm even if

they are not rewarded for those actions.

 

However, the aspect of behavior that has been widely discussed as being

affected by wages is the quality and intensity of work (effort level or

productivity level). Employees realize that even though supervision may not

be detailed enough to detect shirking with certainty, if they are caught

cheating on their promises to work hard and are fired as a result, the loss of

a job paying above market wages is costly. If an employee’s work is not

diligent and he is fired, he faces the risk of earning a lower wage. The cost

of earning less provides the incentive to work hard. Raising compensation

above the level that workers can earn elsewhere has both benefits (less

monitoring costs) and costs (higher wages) to the employer. While initial

increases in pay may well serve to increase productivity and therefore the

profits of the firm, after a point the costs to the employer of further increases

will exceed the benefits. The above-market level at which the marginal

revenues to the employer from a further pay increase equal the marginal

costs is the level that will maximize profits. This has become known as the

efficiency wage (Ehrenberg and Smith, 1997, p. 396). The wage premium

that efficiency-wage employers must pay to discourage shirking depends

upon the alternatives open to their employees. The prediction holds that

there should be a negative association between average wage rates and

unemployment rates across areas (see Ehrenberg and Smith, 1997, p. 582).

 

Shapiro and Stigliz (1984) state in their shirking model that if all

employers were to follow the strategy of raising wages, then the incentive

not to shirk again disappears; the worst that can happen to a worker who

shirks on the job is that he is fired, since he can be rehired (assuming there

is no unemployment) at the same high wage. But as all firms raise their

wages, supply of labor would exceed demand and unemployment would

result. With unemployment, even if all firms pay the same wages, a worker

has an incentive not to shirk. For, if he is fired, an individual will not immediately

obtain another job.

 

Lazear (1979) shows that it is beneficial to both employer and employee

to arrange workers’ pay over time so that employees are ‘underpaid’ (less

than their marginal productivity) early in their careers and ‘overpaid’ later

on. Holding out payments until late in the individual’s lifetime alters the

worker’s incentives to reduce his effort on the job. Workers are less likely to

shirk their responsibilities because the penalties for being caught and fired

are forfeiture of a late future award.

Another form of worker motivation is the promotion tournament.

Workers with high effort levels will be awarded with promotion. Promotion

tournament models are given by Malcomson (1984, 1986) and Bhattacharya

(1986).

 

A contract to induce the employee to provide a certain effort level is

often an understanding that cannot be enforced by third parties, such as

courts. Such contracts are labelled ‘implicit contracts’. It is, for example,

usually understood, but seldom explicitly expressed, that workers who

provide a high effort level will be rewarded with a bonus. Implicit contracts

are distinguished from explicit contracts which can be enforced by third

parties. There is no use for parties explicitly to write down the required

effort level of the employee in the employment contract because courts

generally cannot verify information about the effort level of the employee.

The worker’s effort and thus his output are modeled as nonverifiable

(Carmichael, 1989).

 

6. Long-Term, Incomplete and Self-Enforcing Implicit Contract

 

When the motivation for an employment contract is to regulate and divide

the surplus of relation-specific investments, to ensure a certain income

stream, and to provide incentives to the workers to work hard through

deferred forms of pay, long-term employment relationships are in many

instances conducive to economic efficiency (see Büchtemann and Walwei,

1996). Normally, long-term employment contracts are incomplete. A

contract is incomplete when it does not specify each party’s obligations in

every conceivable eventuality (Hart, 1987). The employment contract might

be incomplete if parties are not able to foresee all future contingencies. If

they envisage contingencies, it may just be too costly to write all those

details into the contract. And even if they want to specify all those details in

a contract, they may be unable to do so in such a way that a court can

enforce their intentions because the necessary information cannot be verified

by third parties, such as courts (see Malcomson, 1997, p. 1917). Even when

legal enforcement is possible, it may be too costly. If parties do not write all

their agreements explicitly down for the reasons just mentioned, they can

still rely on an implicit type of long-term contract. For a review of long-term

and incomplete contracts see Chapters 4100, Contractual Choice and 4200,

Long-Term Contracts and Relational Contracts.

 

It is fruitful to look at the employment contract as a combination of

explicit and implicit agreements. An implicit agreement is an understanding

that is not legally enforceable. We could think, for example, of the informal

understanding between employer and employee that the employee will be

rewarded when his effort level is high or when his attachment to the job is

strong. Implicit contracts are not legally enforceable. This does not render

the implicit agreement valueless. Implicit agreements will be made when

parties can rely on self enforcement of the agreement. The basic idea of selfenforcing

implicit contracts is that if both parties benefit from the continuance

of the employment relationship, they will not cheat on their

promises implicitly made. Self enforcing implicit contracts will exist only if

upholding the agreement will generate a surplus for the two parties

(MacLeod and Malcomson, 1987, 1989). The way in which the surplus is

divided between the two parties is important, because this is what

determines the form of the contract. Among others, Carmichael (1989) has

summarized the potential sources for a surplus of self enforcing implicit

contracts in the labor market.

 

A first source for a surplus in the relationship is savings of direct

mobility costs for each party. One of the earliest approaches (for example

Baily, 1974) was to assume the existence of mobility costs for workers and

costs for the employer of replacing workers. If employers profit more from

the continued employment of their existing workforce than they could from

hiring replacements, they will suffer losses, for example by failing to

promote ‘good’ workers as promised and thereby inducing them to quit.

Investment in specific human capital is a second source for a surplus.

Terminating the contract is unattractive when it makes the investments

disappear.

 

Reputation is a third source for a surplus, as illustrated by Holmstrom

(1981) and Carmichael (1984). If either employer or workers gain a

reputation for breaking contracts when it is in their short term interest to do

so, we might expect them to have difficulty in finding employers or workers

to sign contracts with them in the future, that is they will acquire a bad

reputation which is costly to them in the future. According to Bull (1987)

strong reputation effects require that accurate information about breach of

the agreement flows rapidly to a large portion of the labor market. It is

unlikely that market-based or external reputation will, in many labor

markets, be strong enough to support implicit agreements. While the market

will not have timely, accurate information on the outcomes of trades within

the firm, the information flows within the firms will be fast and accurate. It

is these strong intrafirm reputations that will support implicit agreements.

An unfair breach of a promise on the part of the employer could result in an

unprofitable drop in the morale of the workforce.

 

Efficiency wages can also do the trick. The employee will not quit when

he will earn less elsewhere. If workers are receiving more from the existing

relationship than they expect to receive elsewhere, they will automatically

lose if they shirk on their duties and are fired as a consequence.

 

7. Conclusion

 

It has been shown how parties to the employment contract cope with

imperfections such as asymmetric information, uncertainty and opportunistic

behavior with respect to different areas of the employment relationship. The

employment contract has several roles or functions: to match employer and

employee, to regulate and divide the surplus from relation-specific

investments, to share risks and smooth the income stream and to induce a

high effort level (Ehrenberg and Smith, 1997, p. 394). For many employees,

setting a compensation policy consists of more than just ‘finding out’ the

market wage for given jobs. Paying above-market wages might attract high-

productivity workers, reduce the incentive of the employee to quit after

receiving specific training and reduce the incentive to shirk. Risk-averse

employees prefer certain income streams which leads to the rigid wage result

of implicit contract theory; wages do not fluctuate in response to fluctuations

in the firm’s output price. Rigid wages have also been proposed as a solution

for the hold up problem.

 

Besides explicit agreements, employers and employees exchange a set of

informal, implicit promises regarding their current and future behavior. To

make these implicit contacts self-enforcing there must be a surplus of the

relationship and the challenge for employer and employee is to make

arrangements concerning the division of the surplus.

 


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