Contract Form, Wage Flexibility and Employment

By Thomas Lemieux W. Bentley MacLeod Daniel Parent ∗

The recent recession has brought again build a very simple labor contracting model to the forefront of economic policy debates to explain these facts using three ingredi- the issue of unemployment during economic ents, two of which pre-date implicit contract downturns. Competitive labor market the- theory. The first is the existence of rela- ory predicts that downturns should have tionship specific investment that both (Gary only modest effects on unemployment. A Becker 1962) and (Jacob Mincer 1962) em- decrease in aggregate demand might lower phasized as central to the wage setting pro- output and the demand for labor, but this cess. does not necessarily imply higher unemploy- The second ingredient is contract law for ment. Lower demand for labor leads to which the protection of specific investments, lower wages, with the consequence that some or what legal scholars call the “reliance in- individuals might leave the labor market. terest” (see (L. L. Fuller and William R., The remaining workers need only lower their Jr. Perdue 1936)) is a central goal of con- wage demands until suitable employment is tract enforcement. In particular, if a worker found. makes an investment, such as moving to take The current recession has shown, yet up a job or acquiring some job-specific skills, again, that theory and evidence are on an employer cannot after the fact unilater- a collision course. One hypothesis, going ally reduce wages. Legal doctrines, such as back to Keynes, is that workers lose their good faith and fair dealing, explicitly limit jobs because they are unwilling to accept the scope of firms to reduce wages.2 When lower wages. Implicit contract theory, be- employment contracts cannot be enforced, ginning with (Costas Azariadis 1975) and and firms can unilaterally lower wages, this (Martin N. Baily 1974), and subsequently leads to what (Victor P. Goldberg 1977) calls (Paul Beaudry and John DiNardo 1991), “holdup”, and can lead to an inefficiently low suggests rigid wages are the consequence of a level of reliance by both the worker and the contract between firms and risk-averse work- firm. ers. Yet, (Sherwin Rosen 1985) observes that The final ingredient is asymmetric infor- the hypothesis that wages are the result of mation. (Oliver D. Hart and John Moore an optimal risk-sharing contract implies that 1988) have shown that when there is sym- laid-off workers are no worse off than em- metric information, and contracts are in- ployed workers, a prediction that is inconsis- complete, then rational parties would always 1 tent with the evidence. renegotiate inefficient agreements, leading In this paper we observe that one can to efficient employment ex post, which in turn leads to inefficient investment ex ∗ Lemieux: University of British Columbia and ante. (W. Bentley MacLeod and James M. NBER, email: [email protected], MacLeod: Malcomson 1993) apply these ideas to the Columbia University, Institute for Advanced Studies and NBER, email: [email protected] (cor- employment contract and show that the op- responding author). Parent: HEC Montreal, email: par- timal contract entails fixed wages that are [email protected]. MacLeod gratefully acknowledges renegotiated in the face of better market al- the Russell Sage Foundation and the Leon Levy Foun- ternatives for the worker or the firm. Con- dation for the support of this research. 1(Andrew E. Clark 2003) finds a large negative im- pact of unemployment on subjective well-being, while 2In Rigby v Ferodo [1988] ICR 29, [1987] IRLR 516 (Daniel Sullivan and Till von Wachter 2009) find that the U.K. courts ruled that employers could not unilat- job loss is associated with significantly higher mortality. erally lower wages. 1 2 PAPERS AND PROCEEDINGS MAY 2012 tracts can be designed to achieve efficiency lower the wage in period 2. Firm A pays in a wide variety of cases, including the a monitoring cost c to produce a pub- case of cooperative investment - one party’s licly observable signal s ∈ {0, 1} that is investment affecting both parties’ payoff. positively correlated with firm produc- Such a model, like implicit contract the- tivity. Firm A agrees to pay a bonus b ory, cannot by itself explain inefficient un- if s = 1. employment ((Oliver D. Hart 1983) explic- itly makes the point that asymmetric infor- 2) If the worker rejects both offers, then mation is central to a theory of unemploy- she waits until the firms realize their ment). Following (Robert E. Hall and Ed- productivities, and make new wage of- ward P. Lazear 1984), we suppose that there fers based upon their realized produc- is asymmetric information makes it impos- tivities. She can take up either offer a 2 1 sible for firms to efficiently modify wages ex cost k > k . post. Here, we combine asymmetric infor- 3) If she accepts the offer from say A, then mation regarding worker productivity with in period 2 firm B can offer a new wage relationship-specific investments to produce w2 based on its productivity that she a simple model where wages are set in ad- can choose to accept at a cost k2. vance (consistent with (David Card 1986) who finds that wages are rigid in the short 4) Before production begins, firms can run), and leads to lower employment than choose to layoff workers. Since firm pro- the first best. ductivity is private information, workers We also show that although the measure- will refuse to renegotiate wages down in ment of worker productivity is costly, inef- the event the firm has low productivity. ficient unemployment linked to fixed wages Such behavior is a necessary ingredient can be reduced by introducing bonus pay. of any wage contract consummated in (W. Bentley MacLeod and Daniel Parent period 1. 1999) find that the incidence of bonus pay varies with features of the job aside from Suppose that ex ante the worker is better worker productivity. Comparing bonus-pay matched at A. This model illustrates in the and fixed-wage jobs yields a number of im- most simple form the trade-off between early portant predictions about wages and em- investment into firm A, against the option ployment. First, bonus-pay workers are value of delaying investment if it turns out more likely to be employed than workers that either firm B or exit from the labor mar- on fixed-wage jobs. Second, demand shocks ket is ex post optimal. Notice that asym- should have a larger impact on wages and metric information is a key ingredient here. a smaller impact on employment for bonus- If worker productivity is information that is pay workers. We find empirical support for private to the firm, then workers would never both predictions. agree to wage cuts because the firm may sim- ply be misrepresenting their costs. Wages I. Does Contract Form Matter for can only respond to credible signals, such as Employment and Wages? a wage offer from another firm.3 The model generates a number of empiri- Consider a two-period model that illus- cal implications discussed in the appendix on trates the consequences of specific invest- how contract forms matters for wages and ment, enforceable wage contracts and asym- employment. Most importantly, we expect metric information, the details of which are employment to be higher and less respon- found in the appendix. The timing of choices sive to demand shocks in bonus-pay jobs is as follows: since fixed-wage workers get laid off when- ever productivity falls below w1. The pres- 1) In period 1 the worker can accept a wage 1 offer w from firm A or B and then make 3 1 See (H. Lorne Carmichael and W. Bentley MacLeod a specific investment k - in order to 2003) for a discussion of the credibility of such behavior avoid hold-up the firms agrees not to when contracts are not legally enforceable. VOL. 101 NO. 3 CONTRACT FORM, WAGE FLEXIBILITY AND EMPLOYMENT 3 ence of bonus makes the wage rate (inclu- where Dit is an indicator variable for bonus sive of bonus) more sensitive to demand pay jobs (Dit = 1 if the worker is in a bonus shocks than under fixed wages, and hence pay, and zero otherwise); xit represents stan- the worker faces a lower probability of layoff dard observable characteristics such as po- under bonus pay. tential experience, education, occupation; λi We explore these implications using data is an unobservable ability component; uit is from the Panel Study of Income Dynamics a demand shock that we capture empirically (PSID). In (Thomas Lemieux, W. Bentley using the county unemployment rate; and εit MacLeod and Daniel Parent 2009) we show is an idiosyncratic error term. Note that, as how to exploit the longitudinal nature of the a matter of notational convention, we use PSID to assign workers to either bonus-pay the superscript b for bonus-pay jobs, and f or fixed-wage jobs. We define a bonus-pay for fixed-wage jobs. We also estimate simi- job as a match between a worker and an em- lar equations for hours of work and annual ployer that involves some bonus payments, earnings. The parameters of interest are the including commissions and piece rates. Our coefficients on the bonus pay dummy (δ) re- ported in Table 1, and the coefficients on the analysis is based on a 1976-98 sample of b f male heads of households, where the hourly demand shocks (γ and γ ) reported in Ta- wage rate is obtained by dividing total la- ble 2. bor earnings from all jobs by total hours of As a benchmark, observe that if the mar- work. Given our focus on bonus pay, this ket is perfectly competitive, workers are risk wage measure based on total yearly earn- averse and monitoring costs are orthogonal ings, inclusive of bonus pay, is preferable to the intrinsic utility of a job, then a worker to “point-in-time”age measures that would should be indifferent between the fixed wage likely miss infrequent performance-related in one job, and a compensation package at payments such as bonuses. Our final sam- a job with bonus pay. Moreover, under U.S. ple has 26,146 observations for 3,053 work- law, performance-pay contracts are enforce- ers, 834 of which are “switchers” observed on able under the doctrine of good faith and fair both fixed-wage and bonus-pay jobs. This dealing - namely a firm cannot renege upon allows us to estimate models with worker- a bonus pay commitment by firing a worker. specific fixed effects. More details about Moreover, (James M Malcomson and Frans the data are provided in (Lemieux, MacLeod Spinnewyn 1988) and (Yoshi Kanemoto and and Parent 2009). W. Bentley MacLeod 1992) show that in a competitive market that efficient agency We estimate regression equations for contracts can be implemented with a se- wages (annual earnings inclusive of bonuses quence of competitive performance-pay con- over annual hours), annual hours of work, tracts. Hence, a priori the there should be and annual earnings. Note that since an- no systematic differences between bonus-pay nual hours are the product of annual weeks and fixed-wage jobs. We find that this is and average hours per week, they capture strongly rejected in the data (see below). adjustments at both the extensive and inten- The OLS estimate of bonus pay on wages sive margins. The results are likely driven (Column 1 of Table 1) is positive and sig- by variation at the extensive margin (prob- nificant, but turns insignificant once fixed ability of employment in a given week) in effects are included in Panel B. This is our sample of male heads of households who consistent with the evidence in (Lemieux, tend to work full time when employed. MacLeod and Parent 2009) that bonus pay Consider the (log) wage equation equation is more prevalent in high value jobs. Adding for worker i at time t: fixed effects controls for this source of het- erogeneity, and the fixed effects estimates are consistent with competitive pricing of worker services - bonus pay jobs do not pay (1) wit = α + δDit + xitβ+ f b a premium over fixed wage jobs. Notice that γ (1 − Dit) uit + γ Dituit + λi + εit, bonus pay does make compensation more 4 PAPERS AND PROCEEDINGS MAY 2012

Table 1—The Effect of Bonus Pay on Wages, Hours Worked, and Earnings

[1] Log Wages [2] Hours [3] Log Earnings A. OLS Estimates Bonus-Pay Job 0.0572 81.21 0.1017 (0.0156) (16.23) (0.0153) Bonus Received in 0.0817 61.50 0.1054 Current Year (0.0178) (17.44) (0.0185) B. Fixed Effects Estimates Bonus-Pay Job 0.0175 75.01 0.0615 (0.0134) (19.83) (0.0136) Bonus Received in 0.0401 15.74 0.0457 Current Year (0.0090) (11.72) (0.0087) Note: 26146 Observations from 1976-98 PSID (males heads of household). Bonus pay dummy is equal to 1 if the worker’s total annual earnings are based partly on bonus pay at least once over the course of the employment relationship. Other covariates include polynomials (cubic) in potential experience and tenure, years of completed schooling, and dummies for occupation, industry, race, marital status, collective bargaining, and calendar year. Standard errors (in parentheses) are clustered at the job-match level. variable, because in the year a bonus is paid, mand shocks should have no effect on wages there is a positive effect upon wages. in fixed-wage jobs, there are a number of rea- Column 2 shows that, as expected, work- sons why the effect should still be negative, ers on bonus pay jobs are more likely to be though smaller than in bonus-pay jobs. First employed (higher annual hours) even after some bonus-pay jobs are likely misclassified controlling for fixed effects. Interestingly, as fixed-wage jobs ((Lemieux, MacLeod and the effect of receiving a bonus in the current Parent 2009)). Second, if there is any com- year has no effect on hours once fixed effects mon information between the worker and the are controlled for. This is not consistent with firm, then they could agree to a decrease in fixed wages. It is, therefore, remarkable that the predictions of a standard competitive f model where bonus payment increases the the estimate of γ is not significantly dif- marginal cost of a work, which in turn should ferent from zero, a result that is certainly reduce hours. Finally, bonus pay workers inconsistent with standard models of wage tend to have higher annual earnings because formation. they are more likely to be employed. The Turning to hours of work, Table 2 shows finding that bonus-pay workers have higher that an increase in the local unemployment employment is consistent with idiosyncratic rate has a negative and significant effect for shocks to firm productivity that are more fixed-wage jobs, but no significant effect for likely to result in layoffs for fixed-wage work- bonus-pay jobs. This finding is not consis- ers. tent with the prediction of implicit contract Consider now the impact of the demand theory that employment can be set efficiently even when wages do not reflect the worker’s shock uit affecting all firms. By definition, wages do not respond to demand shocks un- marginal product. In contrast, the combi- der fixed wage contracts implying γf = 0. nation of asymmetric information and firm Since the probability of observing a positive specific investment predicts a negative effect signal (s=1) increases under a positive de- of a demand shock on employment in fixed mand shock, it also follows that γb < 0 (an wages jobs, and a small effect in bonus pay increase in unemployment is a negative de- jobs, which is what we find in column 2 of mand shock). The results reported in col- Table 2. umn 1 of Table 2 are consistent with both In column 3 we report the effect of demand of these predictions. While, in theory, de- shocks on earnings. If workers were fully in- VOL. 101 NO. 3 CONTRACT FORM, WAGE FLEXIBILITY AND EMPLOYMENT 5

Table 2—The Effect of Local Labor Market Conditions

[1] Log Wages [2] Hours [3] Log Earnings County Unem. Rate X -0.0021 -10.73 -0.0076 Fixed-Wage Job (0.0016) (2.62) (0.0019) County Unem. Rate X -0.0072 1.22 -0.0078 Bonus-Pay Job (0.0021) (3.15) (0.0017) p-Value of Test of Equality 0.0490 0.0031 0.9376 Note: Estimates come from unrestricted regressions in which all covariates are interacted with the performance pay job dummy. See the note to Table 1 for more detail about the sample and other covariates included in the regression models. Standard errors are clustered at the county X year level. sured there should be no effect, yet we find tion can improve employment goes back a strong negative effect. We also find that at least to (M. L. Weitzman 1983)’s work the magnitude of the effect is the same in that emphasizes the importance of unfore- both types of jobs, suggesting that ex ante seen events in the theory of unemployment. workers can expect similar patterns in future In his model variable pay takes the form of earnings, consistent with the hypothesis of a profit sharing. Recently, (Omar Azfar and competitive labor market. Stephan Danninger 2001) has shown that in the US profit sharing leads to higher em- II. Conclusion ployment and more investment into train- ing. (Paul Oyer and Scott Schaefer 2005) In this paper, we use data from the Panel extend this point to employment contracts Study of Income Dynamics to study the im- that include stock options. In this paper we pact of local labor market shocks on wages, focus upon individual, as opposed to firm hours of work and employment under dif- level compensation, and show that equilib- ferent contractual arrangements (bonus-pay rium wages do not vary between job types. vs. fixed-wage jobs). Using the county un- We find that employment is higher in bonus employment rate as a proxy for local labor pay rather than fixed wage jobs. Our contri- market shocks, we find that wages are quite bution, relative to the previous work, is to flexible in bonus-pay jobs, but there is lit- illustrate the importance of variable pay at tle evidence of flexible wage renegotiation in the individual level. In particular, our ap- jobs that do not use bonus pay. Precisely proach explains the variation in compensa- the opposite happens in the case of hours of tion form as a function of monitoring costs. work. In principle, profit sharing plans and stock These results, as well as related findings on options are available to all firms, and hence differences in the level of wages, hours, and this earlier work cannot explain the observed earnings under the two types of contracts, heterogeneity in compensation form. are consistent with two uncontroversial hy- potheses – productivity is expensive to mea- Our analysis also suggests a need for more sure and employment entails relationship- research on the costs of measuring worker specific investments. By contrast, conven- performance and worker training, as well tional models with risk-sharing contracts are as having better measures of compensation not consistent with these findings since em- form. In future research we need to under- ployment should be efficiently allocated (and stand how measurement systems vary across not respond excessively to demand shocks) firms, and how the labor market can bet- even when the wage is fixed for risk-sharing ter provide signals to workers and firms on reasons. where they should invest into human capital The hypothesis that variable compensa- and job creation. 6 PAPERS AND PROCEEDINGS MAY 2012

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