Public Disclosure Authorized 2 -.: Public Disclosure Authorized ?,...,,.LC! :I. :;;.;;her:, ar.8 Joseph E. Stic1i.t~ Public Disclosure Authorized Public Disclosure Authorized WAGE RIGIDITY, IMPLICIT CONTRACTS, AVD ECONOMIC EFFICIEKCY: ARE MARKET WGES TOO FLEXIBLE?* David M. Kewbery Develophent Research Department The World Bank and Joseph E. Stiglitz Department of Economics Princeton University August 1982 Revised June 1983 . &Preliminary and Confidential: Not for quotation or attribution wtthout prior ~leciilci~l~eir~u LIZ dutnars. ;'ie;js exp;~,,cld d:~:i;c;e of Th,e ~arhcr-,J~Z 33 not necessarily reflect those oathe World aank or Princeton University. lie - are indebted to Richard Arnott,$ostas Azariadis, Sandy Grossman, Oliver hut * and Arthur Hosios. a m WAGE RIGIDITY, IbIPLICIT CONTRACTS, AND ECONOYIC EFFICIENCY: ARE MARKET WAGES TOO FLEXIBLE? Abstract The analysis of implicit contracts between risk-averse workers and risk-neutral firms must recognize that (i) the contract is implicit, not explicit, (ii) it may only be conditioned on observable variables, and (iii) . there are limits to contract complexity. If contracts are perfectly flexible than neither the constraint of enforceability nor observability result in unemp:oyment. However, even with perfect enforceability and flexibility, linitations on con2racc flexibility may generate unemployment. Finally, even \ with flexible enforceable contracts anti no unemployment the market equilibrium is inefficient. We construct some simple general equilibrium models and explore the consequences of restrictions, on the set of feasible contracts, at the same time comment!ag on the present state of implicit contract theory. The implicit contract theory of wages argues that workers are -re risk averse than firms, and that firms will therefore find it less costly to hire labour if they provide some degree of income insurance against fluctuations in demand which would otherwise lead to fluctuations in the demand price of labour. Wages will be less flexible than in the Walrasian model, and, in extreme cases, will be rigid. Since there is a ~idespredand l~ngstanding belief that wage rigidities give rise to unempl~yment, it is natural to conclude that the risk shifting aspect of implicit ccrrltracts fs responsible for unemployment, and that these risk shifting benofits outwdgh the costs of unemployment. In the strong form 04 chis argument, it is claimed that the resulting levels of unemployment are constrained Pareto efficient , where the constraint is that the absent income insurance markets which give rise to the demand for reduced wage fluctuations remain absermt,- There are five important problems with this theory. First, if: states of nature zre observable to both employers and employees, then tbis axplanation of unemployment fails, for the resulting equilibrium is iderarr+cal to one in which the firm always pays Valrasian wages, and the inaividual. purchases income insurance from an insurance company. The equilibrium Wd entail full emp?.ope;lt, and the income insurance will, if anything, red- the variability in demand. -11 Second, the standard theory -- as well as some of the more recent developments - fails to distinguish between implicit and explicit contracts. The fact that contracts are implicit has several important .- consequences. Thus explicit contracts can relp on third party enforcemegt through the law courts, but implicit contracts cannot. Instead, the firm slst -9- - -11 For earlier discussions on this point, see Stiglitz (1977) and Akerlad and Miyazaki (1983). The ~kerrofand Miyazaki paper, like that of much 4 rhe - implicit contract literatue, does not allow for any variability in 83~~d) number of hours worked by individuals, and thus cannot address some d the 0 central questions at issue. have an incentive to honour the implicit contract, and the most obvious such incentive is the preservarion of its reputation as an employer. 1/ It is important to recognise that there are limits to the enforceability of contracts from 'L-0thsides of the market. Firms have an incentive to cat waees more than the workers expected in bad times, whilst workers may have an incentive to quit in good times even though the firm had continued to pay them throughmt a slack period. (See, e.g. Holmstrom, 1983). The reputation mechanism may work to prevent the first, but not the second. Third, while explicit contracts can in principle contain elaborate and co.qllcatedL In_. provisi,ons which coq&$.>e enforced, it seems unlikely that implicit contracts relying on reputation can be very complicated. The relationship bztween what the parties to the implicit contract can observe and what consequences follow must be clear to both sides, for, by definition, they do not have a written set of rules which specifies consequences for each individual case. Another way to make the same point is that only very simple P'. relatio~shipscan be identified econometrically from past, limited, observations, and more complex relationships would require more data to distinguish from alternatives than is likely to be available. Thus impllcit contracts must have a simple form, and this will greatly limit their ability to provide both full employment and adequate insurance., 31 Fourth, what terms of the contracr are enforceable depends both on . what is observable and whL?t the enforcement mechanism is. Clearly, the terms of any contract can only be contingent on variables observable by both sides of a contract, but if the contract is to be enforced by appeal to a third -21 Myopic self-interest 1s another possible enforcement mechanism - workerr may respond directly to an unjustified drop in thelr wages in such a way as to reduce the firm's profits. The efficiency wage hypothesis argues id'~AAK rrira iiAc1l kdgrr dre CUL -- eltIlt2C LOX nutritional reasons (Bliss and Stern, 1978), or because of a drop in morale. See Calvo a979 ), Shapiro and Stiglitz (forthcoming), Stiglitz (1976), Arnot Hosics and Stiglitz (1980), Weiss (1980), Moore (1982). For a survey 5 some efficiency wage models, see Stiglitz (1983). -3/ The potential importance of restrictions was also noted by Akerlof and bliyazaki (1980). The restrictions which they focused upon, however, were markedly different from those which we consider below. party, the observations must also be verifiable, which is 3 much stronger requirement. Much information is transient, and may be readily observable by workers and their employer at the relevant rnonent, but because it is hard to record, may be imrnedi icely lost and hence unavailable for verification. Reputation mechanisms, r~;t the other hand, do not require the sane kind of verifiability. On the other hand, if a contract is to be enforced by a reputation mechanism then additional constraints on the set of feasible contracts are required: the firm must be better off maintaining its reputation than it would be "breaking" the implicit contract. The earlier implicit contract literature assumed that the state of nature was both observable and verifiable, and thus contracts could be written which were contingent upon the state of nature. The more recent literature &/ recognises that much of the information about the state of nature is neither observable nor verifiable, but fails to give a convincing account of what information is both available and can be used in the design of an enforceable implicit contract. In particular, it fails to introduce into the analysis information which is plausibly available and verifiable (like the aggregate u-employment rate, the price level, product prices charged by other firas, etc.) which would be introduced in any explicit contract which attempted to maximise the expect?d (utility of) profits of the firm, subject to the workers receiving a particular level of expected utility, and subject to various self-selection constraints. (But see Grossman, Hart and Maskin, 1982). In this paper, we shall argue that while the state of nature may nor be directly observable, the probability distribution of wages and hours associated with any firm can be observed. While such informaticn might be irrelevant for the structure of one period contracts which were to be enforced solely by legal leans, it is critical for multi-period contracts, and the fact . e @ r -3a/ See, e .g. A rdriadis and Stiglitz (19837, ilart (1983), Azariadis (1983), Grossman and Hart (1981, 1982), Chari (1983), Green and Kahn (1983) and Cooper (1982). that most implicit contracts are by necessity enforced through a reputation mechanism makes these contracts, implicitly, multi-period contracts. -4 I Fifth, and finally, 5/ the implicit contract literature is concerned with explaining unemployment; unemployment is a macro-econonic phenomenon, yet ith a few exceptions, the implicit contract literature has analyzed only partial equilibrium models. It is only within a model of the whole economy w that one can assess claims about the effect of alternative contractual arrangements on the equilibrium level of employment. Noreover, the frequently expressed claims about the optimality of contract equilibrium / are usually nothing more than the restatement of the problem of contract equilibrium: the firm maximizes its expected (utility of) proflt, subject to being able to obtain workers, i.e. giving them a given level of expected utility (subject to whatever informational or other constraints that are imposed). The solution to this problem is obviously efficient in a partial equilibrium sense, e.g. given the probability distribution of prices, the probability distribution of wages qffered by other firms, etc. However, the relevant question is whether -41 This is a second sense in which the recent literature on implicit contracts with asymetric information is internally inconsistent the fact that such contracts are enforced by reputation makes them multi-period coct-racts,while these papers characterize the optimal one period ccatract. However, with asymetric information, the optimal multi-period contract may look markedly different. For instance, if the rate of discount is zero, and there were an infinite number of periods, equilibrium will be close to that which would have prevailed with symmetric verification.