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# Implicit Contracts Under Asymmetric Information Author(s): Sanford J. Grossman and Oliver D.

Hart Source: The Quarterly Journal of Economics, Vol. 98, Supplement (1983), pp. 123-156 Published by: Oxford University Press Stable URL: http://www.jstor.org/stable/1885377 . Accessed: 15/06/2011 15:56

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**IMPLICIT CONTRACTS UNDER ASYMMETRIC INFORMATION
**

SANFORD J. GROSSMAN AND OLIVER D. HART

A model is analyzed where the firm knows more about its own profit opportunities than do its workers. It is shown that because of this asymmetric information, shifts in the productivity of labor can lead to large variations in employment even when labor supply is very inelastic. This is because the employment level chosen by the firm reveals information about its own profitability. This information is useful in making insurance contracts incentive-compatible. Comparative statics results are derived that show the extent to which firm or worker risk aversion, and the probability distribution of labor productivity affect the optimal employment contract and the equilibrium degree of employment variability.

I. INTRODUCTION

In a Walrasian economy where labor supply is very inelastic, variations in labor demand will lead to variations in the real wage with little or no variation in employment. However, cyclical fluctuations in output seem to be associated with large amounts of employment variability and only small amounts of wage variability (see Hall [1980]). The implicit contract model of employment attempts to explain the low variability of wages in the context of variable labor demand in terms of optimal risk-sharing arrangements between firms and workers (for a survey of this literature see Azariadis [1979]). Unfortunately, when the employer and employees are assumed to share common information, the theory can explain only half of the above phenomenon; the ability to share risk will lead less risk-averse firms to offer more risk-averse workers low wage variability contracts; but if workers' labor supply is inelastic, the optimal contract will also involve low variability in employment (see Akerlof and Miyazaki [1980] and Bryant [1978]). Once we drop the assumption that workers can observe the increase in profit associated with hiring additional labor , however, then this last conclusion is no longer true; the optimal contract may involve high variability of employment, even though the workers' labor supply is inelastic. In this paper we explore in detail the amount of unemployment that is generated due to workers having less information than firms. We analyze the effect on unemployment of risk aversion and the probability distribution of s. It is not difficult to see why under common (symmetric) information, the implicit contract model cannot explain employment fluctuations in excess of those predicted by the Walrasian model. The

(c)1983 by the President and Fellows of Harvard College. Published by John Wiley & Sons, Inc. The Quarterly Journal of Economics, Vol. 98, Supplement, 1983 CCC 0033-5533/83/030123-34$04.40

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firm and workers agree on a wage-employment contract which is ex ante Pareto optimal. That is, if s is the random variable that determines the workers' marginal product, and it can be observed by all parties, then the firm and workers agree on a wage rule w(s) and employment rule l (s) with the property that there are no other rules that can make them all better off. The ex ante optimal rule w (s),l (s) must be ex post optimal in each state s. For if in any state s both the firm and workers could be made better off by deviating from w(s),l(s), then w(s),l(s) would be the wrong rule to choose ex ante. Consequently, the employment rule will call for employment of a worker if and only if his marginal product is above his reservation wage. Since the optimal ex ante employment rule leads to all gains from ex post trade being exploited, the actual employment outcomes with implicit contracts are identical to those that would arise if there was a spot market for labor for each realization of s.1 Consequently, if the supply of labor is very inelastic, then variations in the marginal revenue product will not lead to variations in employment. Recently, models have been developed in which firms and workers have asymmetric information about the state-in particular, where firms have better information than workers.2 Such models, which incorporate certain types of moral hazard or adverse selection, can be shown to provide a considerably richer theory of employment than the symmetric information models. In particular, Grossman and Hart [1981] have shown that the presence of asymmetric information will, under certain assumptions, cause unemployment to be greater than in the symmetric information case or than in the Walrasian model, and unemployment can occur when the marginal revenue product of labor exceeds the reservation wage.3 Our earlier result is based upon the idea that insurance creates moral hazard when the underlying source of risk is not observed by both parties to the insurance contract. In particular, if the net payments made by one party (the firm) must fluctuate in order to achieve insurance and that party is more informed than the other party (the workers), then moral hazard will disrupt the insurance. More importantly, both parties, being cognizant of moral hazard, may decide

1. The conclusion that the employment outcomes are the same as in a spot market depends on the assumption that the worker's reservation wage is independent of his income. We assume this in what follows. 2. See, e.g., Azariadis [1983], Calvo and Phelps [1977], Chari [1983], Green and Kahn [1983], Grossman and Hart [1981], and Hall and Lilien [1979] for some models of asymmetric information and unemployment. 3. The possible importance of asymmetric information has been recognized by a number of authors. See, e.g., Gordon [1976].

there is no clear reason for the workers to prefer one type of contract to the other. However. This means that its wage bill must vary with &. but agree to take a wage rate cut in bad states of the world. the firm may wish to misreport the state. In particular. given the "variable wage-fixed employment" contract. This is because its wage-employment implicit contract is defined in terms of quantities that are immediately observable. in the long run workers will be able to verify the truthfulness of the firm's announcements. however. even if s is correlated over time or the discount rate is positive (so Radner's result would not hold).. In this paper we shall study a "one-shot" situation. however. firms can develop a reputation for their wage-employment policy. It might be thought that.IMPLICIT CONTRACTS UNDER ASYMMETRIC INFORMATION 125 to change the employment rule to be ex post inefficient as -a method of generating an ex ante optimal contract. assume that the firm is risk-averse with respect to its profit stream (In Section VI we provide a justification for this. For then the workers must rely on the firm to tell them which state has occurred. In the other ("fixed wagevariable employment"). and so the "variable wage-fixed employment" contract becomes a "fixed (low) wage-fixed employment" contract. To understand the basic issue. Thus. Our results should. In general. Consider two different contracts that the firm might offer its workers.g. See Radner [1981]. its wage bill must be low when s is low. the "fixed wage-variable employment" contract is 4. this requires stronger assumptions than are necessary for the firm to establish a reputation about layoffs. e. . since this allows the firm to reduce wages without sacrificing employment. workers are guaranteed employment. This problem will be less serious if workers can observe variables that are correlated with the state in this firm. the state in the industry as a whole. actual wages will always be low. it is always in the firm's interest to claim that a bad state has occurred.4 In contrast.) This implies that it is never optimal for the firm to bear all the risk of the variations in profit caused by s. For then workers need only check that the firm is telling the truth on average. In one (the "variable wage-fixed employment" contract). if only the firm can observe the state. In a world where both the firm and the workers observe the state ex post.In particular. where average truthtelling cannot be verified over a long period. since the implicit contract model is based upon the idea that firms establish reputations. generalize to "many-shot" situations in which the firm's shocks are serially correlated or the time horizon is relatively short or there is discounting. Thus. Workers can observe immediately whether the firm deviates from an announced wage-employment schedule w(l) to be defined below. however. Matters change considerably. The moral hazard problem will also be reduced if the firm and workers have a very long relationship with each other and (1) the shocks (states of the world) that the firm is subject to are independent over time and (2) there is no discounting. Each of these contracts permits the wage bill to vary with s and shifts some of the risk from the firm to the workers. even though the contract may specify that wages should be high in good states and low in bad states. workers are guaranteed a particular wage rate but may be laid off (or made redundant) in bad states.

the efficiency losses due to &'(l) > R are of second order. Hence. Our argument assumes that the reservation wage is a constant R and is motivated as follows. For the reason given above. where w is the total wage bill and 1is labor supply. i. where f is the revenue function. With i'(l) > R.e. This possibility does not seem very attractive.. Furthermore. unproductive). w can vary with s only if it is accompanied by 1 varying with s.RI = w(0) which is a constant independent of the state s.5 Though Grossman and Hart [1981] show that there will be ex post inefficient unemployment. The main result of Grossman and Hart [1981] is that a Pareto optimal contract will generally involve some unemployment in states of nature where a worker's marginal product is above his reservation wage. the firm has a lower wage bill than under the contract w (1). given a wage schedule that has ex post efficient employment (i. there will be states of nature where the workers' marginal product is larger than their reservation wage and hence there is underemployment. bad). they do not analyze the determinants of its magnitude. As a consequence. but that wage rates should remain constant. for this contract specifies that layoffs should occur in bad states. The firm and the workers agree ex ante on a Pareto optimal member of this class. all the firm achieves is a loss (respectively. Suppose instead that the firm and the workers agree on a new contract &(1) with wi(l) > R and d(0) < w(0).126 QUARTERLY JOURNAL OF ECONOMICS less obviously open to abuse. Thus. For a small twist in the schedule. This is clearly suboptimal when the firm is risk-averse. since at w'(l) = R the net marginal benefit (or loss) involved in a small deviation in employment from the optimum is zero. it has effective control over employment and so for a policy to be implementable l (s) must maximize the firm's ex post profit f (s. Therefore. This implies that the workers' wage bill is given by w (0) + RI. .. Thus. or else the firm would not be choosing I to maximize profit. In general. We may conclude that the "fixed wage-variable employment" contract may be implementable in a way that the "variable wage-fixed employment" contract is not. This must mean that w'(l) = R for all 1.This means that the net income of the workers (net of disutility of effort) is w(l) . the firm has a less risky profit stream than under w (1).w (l) for each s. by claiming that the state is bad (respectively. gain) of labor at a time when this labor is relatively productive (respectively. good) when in fact it is good (respectively. Suppose that contraryto what we claim. the workers bear no risk. a wage schedule d(l) always exists that can make the firm and the workers better off and has the property that &'(l) > R. and the firm bears all the risk. Here we shall be interested in how the amount of employment explained by the implicit contract-asymmetric information theory-over and above that explained by Walrasian theory-depends on such exogenous variables 5.l) . the implementable policies can be thought of as w(l). under &(I).l(s)). when &is low.e.l(s). where the wage bill is taken to be a predetermined function of the labor utilization. This twisting of the wage schedule means that in bad states of nature. w'(l) = R). there will be a set of variable wage-variable employment contracts that are implementable (w(s). since only the firm observes s. workers are always employed to the point where their marginal product equals the reservation wage.

If the worker is employed. the workers' risk aversion. but it should be noted that our results generalize to the case of a firm which makes a contract with many workers under the assumption that each worker can observe only whether or not he is employed. II. and employs. Finally. and perhaps other variables too. etc. Here R represents the worker's . The paper is organized as follows. concluding remarks appear in Section VI. but not how many other workers are employed by his firm. his utility is U(W . Let G be the distribution function of s. are observed by the workers. In Sections IV and V we consider how unemployment is affected by changes in the probability distribution of the marginal product of labor. his utility is U(W').IMPLICIT CONTRACTS UNDER ASYMMETRIC INFORMATION 127 as the firm's risk aversion. Analyzing the effect of risk aversion and productivity on unemployment in a general model in which each firm makes a contract with many workers is difficult. In Section II the model is described. Getting some idea of the importance of these factors would seem to be an essential step toward assessing the empirical significance of the implicit contract-asymmetric information theory of employment. G (s) = 1 for some s < s-. We assume that G (s) = 0. Each worker has a von Neumann-Morgenstern utility function U. which is positive for s < s < g. It is to be hoped also that our results will be a useful starting point for the analysis of the many-worker case when total employment within the firm. the productivity of labor.We assume that G has a continuous density function g(s). The comparative statics results that we obtain may also provide a way of distinguishing at the empirical level between the implicit contract-asymmetric information theory and other theories of unemployment (see also Section VI). All potential workers are assumed identical. If employed. Consider a (representative) firm that can employ at most one worker. where W (respectively. unemployed). a single worker. the output or revenue (we shall not distinguish between the two) of the worker is given by the random variable s. W') is the worker's wealth when employed. In Section III we analyze how unemployment is affected by changes in the risk aversion of the firm and worker. THE MODEL The model is based on that of Grossman and Hart [1981]. the workers' reservation wage. (respectively. This is obviously a very special case. We shall therefore simplify matters considerably by confining our attention to the case where a representative firm makes a contract with. and if he is unemployed.R).

6 We shall assume that s > R. At date 0. the worker is unemployed. 8. V.) Thus. If production does occur at date 1. there is asymmetric information at date 1. Finally. the firm and worker have symmetric information. We shall call R the worker's reservation wage.. particularly if workers have better information about the realization of R' than does the firm. the firm learns the realization of s. The model is a two-period one. the firm's output is s. as described above.e. that at date 1. when the contract is signed. or to put it another way. before any employment decisions have to be made. 7. We shall assume that the worker'sreservation wage is independent of his wealth W. the firm's output is zero. if we assume that a contract has been signed. see Chari [1983] and Green and Kahn [1983]. At date 1. his productivity elsewhere is zero. is assumed not to observe s.. in contrast.128 JOURNAL OF ECONOMICS QUARTERLY disutility of effort. he cannot work anywhere else at date 1. See Section VI and footnote 4 for a motivation for the asymmetric information assumption. It is also assumed that if the worker signs a contract with this firm. i. The only effect this has is to increase the effective opportunity cost of labor or reservation wage from R to (R + R'). however. The worker.7 We suppose that at date 0. For models in which the reservation wage is allowed to depend on wealth. the worker is employed. We shall suppose. which could be relaxed. There is no difficulty in generalizing the model to the case where at date 1 the worker can earn a certain amount R' > 0 elsewhere if he is laid off by this firm. The contract will specify under what conditions they will occur. We shall suppose that the attitudes to risk of the firm's owners can be represented by a von Neumann-Morgenstern utility function of profit V(wr). the firm decides whether to sign a contract with a worker.8 Thus.. but that cannot readily be transferred to other firms. and R are known to both parties at date 0.e. production and employment can occur. One can 6. G is known to both parties. Matters become complicated (and more interesting) if R' is a random variable. it is the amount that he must be paid to compensate him for working. the marginal product of labor exceeds the reservation wage with positive probability. however. . but that the realization of s is known to neither. i. This is an extreme assumption. we have in mind that the period between date 0 and date 1 is a training period during which the worker acquires skills that are useful for this firm. we suppose that there is a minimum level of expected utility U that the worker must be offered by the firm if it wishes the workerto sign a contract at date 0. What we are trying to model is the idea that the worker is generally less productive in other firms at date 1 than in the firm with which he has signed the contract-that is. i. No actual production or employment occurs at this date. (We also assume that U. at date 0.e. If production does not occur.

(2) his wage w(s). see Azariadis [1979]. s is observed by both parties at date 1. In contrast. It is helpful to begin by considering the case where. It is important to emphasize the different assumptions that we make about the mobility of labor at dates 0 and 1. a. a contract that maximizes the firm's expected utility subject to the constraint that the worker's expected utility is at least U.. U' > 0. by the time firm-specific skills have been acquired at date 1. V is defined and twice differentiable on an interval 5 = (a/. i. labor is highly mobile. See Grossman and Hart [1981]. we make the following assumptions about U and V. A2.e.L(s). we permit layoff (or redundancy) pay. where L(s) = 0 or 1 for each s.e. U" < o on Y. Then a contract can make both wages and employment at date 1 conditional on the realization of ?.. Unless other considerations are introduced. indicating for each state (1) whether the worker is employed (L (s) = 1) or unemployed (L(s) = 0).10 When s is common knowledge. In addition. it is common knowledge.oo) of the real line and limx-a' V(x) = -O. 10..IMPLICIT CONTRACTS UNDER ASYMMETRIC INFORMATION 129 imagine that there are many identical firms and workers trying to find partners at date 0.s < s < s). i. The market for contracts at date 0 is taken to be a standard Walrasian one. Al. i. a contract under symmetric information is a pair of functions (w(s).e. U is defined and twice differentiable on an interval Y = (a. In addition. Note that we allow w(s) > 0 when L(s) = 0. This is in contrast to much of the implicit contract literature. in contrast to our above asymmetric information assumption.. oo) of the real line and lim. our model does not explain (involuntary or non-Walrasian) unemployment at date 0. In (Al) and (A2) we allow for the possibility that a or a' =O. V' > 0. Thus. In order to proceed. and that U is the market-clearing "wage" (in expected utility terms) in the market for contracts.. V" < Oon 5'. i. At date 0 it is assumed that workers have not yet acquired firm-specific skills and therefore could work in a large number of different firms.9 The Optimal Contract We wish to study the form of the optimal contract between the firm and worker at date 0. Thus.e. . Allowing layoff-redundancy pay changes the form of the optimal employment rule both when s is common knowledge and when it is observed only by the firm. it is easy to characterize an optimal contract. there seems no reason to rule out layoff-redundancy pay in the present model. mobility is assumed to be much reduced (in the extreme case considered here it is taken to be zero). U(x) = -O. Note first that any contract which is ex ante optimal at date 0 before s is known must be ex post optimal at date 1 for each realization of s (for if both the firm and the worker can be made better off in some 9.

. We suppose. i. The reason w(s) is constant over unemployment states is that social output is constant (equal to zero) over such states.w(s)) (21) *~ ~~~V U (W. See Azariadis [1979]. it can be shown that without layoff-redundancy pay the ex ante optimal employment rule is employ if and only if s > k.R + E.) V(-Wu) over states s. where L(s) = 1. and U'(w(s) . Equation (2.It follows that any ex ante optimal contract must specify the employment rule: employ if and only if s > R. then both parties can be made better off by letting production occur and increasing the wage from w(s) to w(s) + R + E. We suppose that. Under (A1)-(A2). where E > 0 is small. e. We analyze the optimal contract in terms of the following revelation game. This will be chosen to ensure optimal risk sharing between the firm and the worker. at date 1. this involves choosing the wage function w (s) such that w (s) = we. where k is a number less than R. For if production does not occur in some state s > R. we will be chosen so that the worker's expected utility equals U. Finally.g. which satisfy L(s) = 0. If layoff-redundancy pay is ruled out. the firm is asked to announce the realization of g it has observed. however. This argument depends on the possibility of layoff-redundancy pay. Now a necessary condition for ex post Pareto optimality is that production should occur if and only if s > R. The contract then specifies a wage w(s) and an employment level L(s^)(equal to zero or one).1) is the condition that the marginal rate of substitution between income in employment and unemployment states should be the same for the firm and worker. both parties can be made better off by stopping production and reducing the wage from w (s) to w (s) . conversely.e. at date 1. There it is shown that in studying the optimal contract attention can be confined to the case where truthtelling is an optimal strategy for all agents (see. if production occurs when s < R. over the states s. ..R) V'(s . whether L(s) = 0 or 1. then their expected utilities at date 0 can be increased).130 QUARTERLY JOURNAL OF ECONOMICS state s and no worse off in any other state. s is observed only by the firm. In fact. it is no longer the case that ex ante optimality implies ex post efficiency.11 The remaining part of the optimal contract when s is common knowledge at date 1 concerns the wage function w(s). 11. There is an obvious and unimportant ambiguity when s = R. We turn now to the more interesting case where. conditional on the announcement s = s'. that the worker does observe whether he is employed at date 1. Matters can be simplified considerably by appealing to results from the incentive-compatibility literature. a constant.

see Remark 1 below and Section V). Then the condition that truthtelling is optimal implies that w (s) equals a constant we on E and that w(s) equals a (possibly different) constant Wuon U. if U is empty. and vice versa when s < k. the firm will pretend that s = S2 when s = si. the firm will pretend that the state which has occurred lies in E. The state s = k can lie either in E or in U. Thus. In both cases E = IsIs > k . and U = IsIs < k}. if w(s1) > w(s2) where sl. s < k. given the form of the optimal contract.s2 e E. if s d E. k = s. since by doing this. Neither of these possibilities is consistent with truthtelling. Note also that.12 For whenever s > k. we can deduce the wage when employed. we may assume without loss of generality that the contract is such that the firm always wishes to report the true state. it can reduce wages without sacrificing employment. the extra amount the firm has to pay to employ him at date 1. 13. a contract in effect specifies two wages: wage we when the worker is employed at date 1. In other words.wu). and Maskin [1979]. since it occurs with probability zero (however. We do not bother about this state. there is an indeterminacy in k: any k ' s (respectively. if w(s1) > w(s2). unemployment always). and the employment rule: employ if and only if s > k. and Myerson [1978]). and if s d U. the wage when the worker is unemployed at date 1. we can always set wu = we. similarly. From this.s and k = s without changing anything. we = wu + k. and k.s2 E U. we can set we = wu + s. s > k. and if E is empty. under asymmetric information. a contract can be characterized by two numbers: wu. 12. > s) will do. Instead we can imagine that given the wages wu and (wu + k). Let k = (We . the firm gains more from employing the worker than it has to pay for this employment. the firm will pretend that the state which has occurred lies in U. Hammond. and wage wu when he is not employed at date 1.IMPLICIT CONTRACTS UNDER ASYMMETRIC INFORMATION 131 Dasgupta. This argument assumes that E and U are nonempty.13 We see then that in the case where only the firm observes the state at date 1. We rule out this indeterminacy by adopting the convention that s ' k ' s. However. where s1. Thus. . Note that in the case where there is full employment always (respectively. Then the condition that truthtelling is an optimal strategy tells us that E tsIL(s) = 1}= sls > k} and U IsIL(s) = O}= Isls < k}. Let E = {s IL (s) = 1} be the set of employment states and U = Is IL(s) O}be the set of unemployment states designated by the contract. there is no need for the firm actually to report s at date 1. the firm simply chooses whether or not to employ the worker at date 1. For.

since the insurance is conditional on the announcement s and. We assume that V is defined for some levels of negative income (if W.w>) for some function W. the firm's actual profit will be a deterministic function of s. which maximizes Ss k (2. once this announcement is made. Thus. where the realization of &(s) and L(s) is determined by an objective lottery. where 7ro2 Wu. In the situation given in the text.k)g(s) ds + V(-wu)g(s) ds U(wu + k . the worker receives a net income of (wu + k . if the worker cannot monitor (and hence prevent) such insurance.R)EY. DEFINITION.wu sat14. one can imagine that the firm earns profit 7ro elsewhere which is sufficient to cover its wage bill. . (A1)-(A2) also ensure that as long as the constraint set is nonempty.3) gives the worker's expected utility.4) V(s .w (s). when the set of feasible employment and output levels is convex. there are k .2) is the firm's expected utility. note that it may be difficult to implement a random contract. if not. it can be shown that stochastic contracts have no advantage over deterministic contracts.G(k)) + U(wu)G(k) 2 U WUEf. that is.2) subject to (2. In particular. the realization of L (s) and a(s) are determined by an objective lottery over which the firm has no control. i.w) = W(7ro. the firm will always wish to go to a (risk-neutral) insurance company and arrange that.3) will hold with equality.. the firm can always increase profit by reducing wu. the insurance company will guarantee the firm a certain income of E[sL(s) . Alternatively.R)(1 . to specify a random wage iv (s) and employment level L (s) conditional on the announcement s. L is discrete. i. Note that there is no moral hazard in such an arrangement. if at date 1 the firm announces that the state is s. we have confined our attention to deterministic contracts.Wu. Expression (2. An optimal contract under asymmetric information is a pair (wuk). In the above. 15 The left-hand side of (2.e. However.3) and (2. Maskin [1981] has shown that it may be desirable to make the contract stochastic. ? 0).e. where w(s).k) An optimal contract is one that maximizes the firm's expected utility subject to the worker's expected utility being at least U. since. Under such conditions. L (s) is the outcome of the lottery.. that is. Such schemes make the firm's profit sL (s) . Under (A1)-(A2).C(s)] in exchange for the firm giving the insurance company sL (s) . so there is some benefit from randomization that will disappear when L is a continuous choice variable and the production function is concave. (wu + k . having signed such a contract. A contract when only the firm observes the state at date satisfying s < k < . -wuEY.iV (s) a stochastic function of s. (2. since when s > k the worker is employed and paid (k + wu).132 QUARTERLY JOURNAL OF ECONOMICS DEFINITION..14 1 is a pair (w.V(. we have assumed that the contract specifies a certain wage w (s) and employment level L(s) for each s announced by the firm. s < k s. while when s < k the worker is unemployed and paid wu. 15. Recently.R) when employed and wu when unemployed.

.R). provides some information about the form of an optimal contract. the probability of unemployment is G(R)). an optimal contract exists. Let (WUk) be an optimal contract.. In general.3)-(2.e. and this yields efficient employment. this wage path can be realized under asymmetric information by setting k = R. U(w-) = U. i. depending on the exact form of U. i. (In contrast.IMPLICIT CONTRACTS UNDER ASYMMETRIC INFORMATION 133 isfying (2.e..16 Proposition 1(2) says that the probability of unemployment will still be G (R) under asymmetric information if the firm is risk-neutral.) The proposition below. -wd0'.e. .G. Since the firm's expected utility 16. Proposition 1(1) tells us that the probability of unemployment at date 1 will never be lower under asymmetric information than under symmetric information or than in the usual Walrasian model of the labor market (in the latter two cases. we are referring to the standard model in which there are no training costs or locking-in effects. The nonemptiness of the constraint set is guaranteed by (A3). i. If the firm is risk-neutral. and where there is simply a spot market for labor at date 1. If R < s. there may be more than one optimal contract. there is full employment under symmetric information. When we speak of the Walrasian model. Proposition 1(3) says that the probability of unemployment will be greater than G (R) under asymmetric information if (a) the firm is risk-averse. if the probability of unemployment is positive under symmetric information. k = max(s.. Proposition 1 says that the optimal k may exceed s or it may equal s. (3) if R > s and the firm is risk- averse. which was also proved in Grossman and Hart [1981].e. (2) if the firm is risk-neutral. i. ex post efficiency is always achieved and so unemployment occurs if and only if s < R. unemployment will not occur in states close to Th Proof of Proposition 1. and (b) R > s.2)-(2. in an optimal contract. For when V' = constant. unless both the firm and the worker are risk-neutral. the solution of (2. V" (or) = 0 for all wrEY'. Then (1) s-> k > R.4). then k > R. V"(wr)< 0 for all 7 E Y'. However. This is because the maximization problem in (2. when s is common knowledge. that is. Assume (A1)-(A3). We will consider this case further in Section V. there may or may not be unemployment under asymmetric information. i. the optimal contract under symmetric information can be implemented even when there is asymmetric information. the optimal contract is unique. V.4) is nonconvex.1) is w(s) = wu + R for s satisfying L(s) = 1.. Note finally that Proposition 1(1) also tells us that. PROPOSITION 1. There exists i satisfying wd0.e.

Remark 1. since U'(wu + k .R) > U'(wu) and U(wu) > U(wu + k .U(wu + k .5) -fk)dG V'(s .R)(1 . Proposition 1 holds for the case where G has a density function g. Q. if k < R. it is clearly optimal to make s = k an employment state if k > R (since then we = Wu+ k R > wu and so the worker prefers to be employed) and an unemployment state if k < R (since then we = wu + k .e. Note that when G is discrete.) Since V'(s .. (If k = s. the right-hand side of (2. Hence (2.5).k) dG + V'(-wu) dG U'(wu + k . These yield V'(s -kWd (2. For when k = R.5) > (1 .4). if k = s-. with equality in (2. Note also that the first-order conditions are not satisfied at k = s-.3).k) < V'(-wu) when s > k.5) = (1 .5) < (1 . we must replace the equality by >. If V" < 0. We prove part (1) for the case R > s. If the worker cannot observe s. This proves that k > R.5) cannot hold when s < k < R < s-.k) < V'(-wu) for s > k.134 QUARTERLY JOURNAL OF ECONOMICS can clearly be no higher under asymmetric information than under symmetric information (any contract that is feasible under asymmetric information is feasible under symmetric information).D.G(k)) + U'(wu)G(k) if s < k < s-. since V'(s . the left-hand side (LHS) of (2.Wu. the right-hand side (RHS) of (2.G(k)). this proves part (2).G(k)). although part (3) may not (i. Since the firm is indifferent between employment and unemployment when s = k.G(k)).R))g(k) U'(wu + k .E. However. If G is discrete. the above argument shows that k = R also does not satisfy (2.On the other hand. we may have k = R).R)(1 .Wu. Proposition 1 supports the intuition given in the introduction. Consider the first-order conditions for the problem (2. This establishes part (3).G(k)) + (U(wu) . it can be shown that parts (1) and (2) still hold. but only on observed variables determined by s.by <. wages cannot be conditioned on s directly. such as em- . Hence part (1) is true. it matters whether s = k is an employment state or an unemployment state.2)-(2. while the left-hand side < (1 . the first-order conditions are also not satisfied if s = k < R.Wu .G(k)). Note that part (1) clearly holds if R < s. since k > s.R < wu and so the worker prefers to be unemployed).R).

. For this reason. it may be desirable at date 0 to agree to let unemployment occur in states where the marginal product of labor exceeds the reservation wage. the consumer-worker has information about his ability that the government does not. Finally. but because of moral hazard this is not possible)..e. i. The firm would like to make wages depend on this information directly. + k .e.. it may be necessary for employment to vary more than is desirable from an efficiency standpoint. in order to get the right degree of risk sharing. whereas in the tax model one thinks of the government taxing a large number of different people in different states.IMPLICIT CONTRACTS UNDER ASYMMETRIC INFORMATION 135 ployment. There is a close formal relationship between the model presented here and optimal income tax theory (see Mirrlees [1971]). The government would like taxes to depend on ability directly. that the level of employment under asymmetric . This is because this is the only way that the (risk-averse) firm can reduce its wage bill in times when s is low (the firm would like to reduce wages without sacrificing employment. the government in the tax model needs to balance demands and supplies only in average or expected terms. In the taxation problem. Note that in the implicit contract model one considers a contract between a worker and one firm which may end up in one of a large number of states. In contrast. labor supply or income. Remark 2.> We = w.R > wj) and hence the worker regrets the fact that he is unemployed. the government is risk-neutral. but instead must base wages on the consequences of this information. our result that unemployment will not occur in states close to s. but instead must base taxes on the observed consequences of ability. As a result. Thus. i. employment levels.. in the contract model one is interested in the case where the worker may be risk-averse. It is voluntary in the sense that the worker is a willing party to the contract at date 0. the worker (the uninformed agent) in our model corresponds to the government (the uninformed agent) in the tax model and the firm to the consumer-worker. i. in terms of this paper. In our model the firm has information that the worker does not.e. It is involuntary in the sense that the worker is better off in employment states than in unemployment states (for k > R . Note also that our result that k > R is exactly analogous to the result that the optimal marginal tax rate is positive-both results imply that the utility of the uninformed agent (the utility of the worker or the revenue received by the government) is higher the better is the state or ability of the informed agent (the firm or the consumer-worker). in particular in states satisfying k > s > R. One may ask whether the unemployment that occurs at date 1 is voluntary or involuntary.e. In particular. i.

and that obtains comparative statics results for some special cases. .R) < k < s.R)(1 .3) is increasing in w1. is as in Figure I.R). 17. given by (2. Proposition 1 tells us that the probability of unemployment will exceed the Walrasian level only if the firm is risk-averse. = Clearly w. The left-hand side of (2. Finally.) Thus.136 QUARTERLYJOURNAL OF ECONOMICS information is equal to the Walrasian level in the best state of nature. if R > s. For the remainder of the paper we shall assume that the firm does find it in its interest to make a contract with a worker at date 0.thatis. (3. (s) = U-. How THE RISK AVERSION OF THE FIRM AND WORKER AFFECTS THE LEVEL OF EMPLOYMENT In the last section we saw that an optimal contract under asymmetric information is generally characterized by unemployment in excess of the spot market level or of the unemployment under symmetric information. Proposition 1 is generalized to the case of a firm that employs many workers in Grossman and Hart [19811. is differentiable for s > k > max(s.where U(MO) U (the existence of UT is guaranteed by (A3)).2).(k). is also a function of wu. but may be increasing or decreasing in k (an increase in k raises the wage when employed but reduces the probability of employment). w.1) exceeds U when wu = w-.3) to write wu as a function of k: Wu=wu(k). we can draw indifference curves for the firm in Figure 1. (R) = w. it is useful to investigate the constraint (2. (k) + k . In this section we consider how this excess unemployment depends on the degree of risk aversion of the worker and firm.k. In order to answer this and other comparative statics questions. Also. (Note that EV is decreasing in wu and in k.G (k)) + U(w. is analogous to the result that the marginal tax rate should be zero for the most able (see Sadka [1977]). for max (s. for s > k > R.1) U(w.17 III.3) when there is equality. We know from the proof of Proposition 1 that. the left-hand side of (3. The firm's expected utility EV. is Weitzman [19801. (k))G (k) = U. We therefore use (2. It is therefore natural to ask whether the probability of unemployment increases as the firm becomes more risk-averse. A paper that adopts a somewhat similar approach to that taken here. The model presented here is also an example of the principal-agent problem. Hence w.and therefore wu(k) < 6-.

if (&. Proof. it is not sufficient to differentiate the first-order conditions (2. PROPOSITION 2. if s < R. The optimal contract is at k = k in Figure I. An increase in k increases the wage that the worker is paid in employment states.j) is an optimal contract before the change and (&'.5). increasing.IMPLICIT CONTRACTS UNDER ASYMMETRIC INFORMATION Wu 137 Wu w k k EV= constant EV = constant FIGURE I dwl dk E V=constant - -LHS of (2. hold before and after the change. This will change the slope of the firm's indifference curves. Then. As a result. every optimal contract will satisfy k > R. Suppose now that the firm becomes more risk-averse. Furthermore. In other words. Note that to prove this proposition. See Appendix. P' > I. strictly concave Assume that (A1)-(A3) function defined on the range of V(wx). The intuition behind Proposition 2 is the following. We now show that this will have the effect of increasing the optimal k and thus increasing the probability of unemployment G(k). the firm's indifference curves are less steep than the worker's at k = R. and this enables the firm to reduce wu(k). which restates Proposition 1. It is thus clear from the diagram that if R > s. h' > i. Let the firm's utility function V be replaced by H(V).. where H is a differentiable. the firm's profits become less risky in a well-defined sense-they rise in bad unem- .P') is an optimal contract after the change. since (1) these are necessary but not generally sufficient and (2) there may be more than one optimal contract.5) > -RHS of (2.5) dw| dk ElIT=constant at k = R.

It should be noted that when the worker's risk aversion changes. The next proposition establishes this for the case where the worker'sand firm's utility functions exhibit constant absolute risk aversion. i.Is there an upper limit to the optimal k as the firm becomes more and more risk-averse?To answer this question. . however. to the more risk-averseis the firm.. let k* be the smallestof these). to "maximin. an increase in k causes wages when employed to rise but when unemployed to fall. which makes the worker's net income riskier. This suggests that an increase in the worker's risk aversion may reduce the optimal k.where wu(k) satisfies (3.k)is an optimalcontract. and real= izingfeweremploymentstates. it would be paying a higher wage both when the workeris unemployedand employed. (2) given E > 0. For if it did so. It is clearthat no firm. Proposition 3 is easy to understand. This is done by setting k = k*. PROPOSITION Assume (A1)-(A3). We shall write U = U(0) as in (A3) and assume that the worker can continue to get the certain income w if he goes elsewhere at date 0. so that if the utility function U is replaced by U. We now consider the influence of the worker's risk aversion. minimizeswu(k)." Profit in unemployment states -w.whatever attitudesto risk. A very risk-averse firm wishes approximately to maximize income in the worst state. any optimal contract has the property that Ik . Hence the firm wants to maximize -wu(k). Let k* be the smallest k that 3. We have argued that an increase in k makes the firm's profit stream less risky (in some sense). it is helpful to look at Figure I. The next we proposition shows that as the firm becomes more and more riskaverse. k will convergeto k*. the worker's opportunity cost of labor at date 0. (k) is less than profit in employment states s .This opportunity reduceriskis moreattractive.k .1). then U is replaced by Cf(-i). Wu wu(k*). Then (1) if (wuk) is an optimalcontract.V"(r)/V'(w)) > a for all ir. Let k* be the value of k that minimizes (k) Wu (if there is morethan one k that minimizeswu(k). Hence if (wu. its would ever select k > k*. if (.. this will also generally lead to a change in U.138 QUARTERLY JOURNAL OF ECONOMICS ployment states and fall in good employmentstates (expectedprofit may. See Appendix.e. musthavek < k*. there exists a such that. The opposite is true of the worker.k < Proof. Proposition 2 says that k increases as the firm becomes more risk-averse. Propositions 2 and 3 tell us how the probability of unemployment depends on the firm's risk aversion.wu(k).fall).than if it selectedk = k*.k < k*.

Assume (A1)-(A3). Then (1) if (wak) is an .G(k)). given e > -e -bi and the worker's utility function by U(w) = -e -aw.e. ranging from G(R).IMPLICIT CONTRACTS UNDER ASYMMETRIC INFORMATION 139 PROPOSITION 4.wu(k).max(s. the Walrasianlevel. this last result is true in the generalnon-exponential case.In fact. i.R)(1 .k') an optimal contract when a = al > a.G(k)). PROPOSITION 6./)is an optimal conis tract when a = ao and (dW. in the exponential case. Then. and so k* is the smallest value of k that maximizes (k . then E'< A.Also let U = -e-aw. as the next propositionshows. The intuition behind Proposition5 is that if the workeris very risk-averse. PROPOSITION 5..The next proposition tells us that k will be very close to max(s.we can askwhathappensto the optimal k as the worker'srisk aversionbecomes very large. Assume (A1)-(A3).R) underthese conditions. Let T be the smallest value of k that maximizes (k . The the probabilityof unemploymentwill be higherthe morerisk-averse firm is. In the exponential case the probability of unemployment will also be higher the less risk-aversethe workeris. reachingits minimumlevel G(R) when the workeris infinitely risk-averse(the last statement is also true in the general non-exponentialcase). It follows fromthese results that. where 0.R)(1 . when the firm is risk-neutral(see Proposition1).if s < R. Then. any optimal contract has the propertythat Ik . there are no wealth effects. wu(k) = U-(k . if we regardas variableboth the firm'sand the worker'sutility functions.R)f < e. Proposition 4 does not appear to hold for generalutility functions. when the firm is infinitely risk-averse. to G(k*). to R if R > s. Note that when the workeris risk-neutral. See Appendix.R)(1 . since then wu(k) + k . See Appendix. We may summarizethe results of this section as follows.the probabilityof unemploymentis at its greatest when the firm is infinitely risk-averseand the worker is risk-neutral. there exists a such that if (-U" (w)IU'(w)) > a for all w.R . Proof. Let the firm's utility function be given by V(r) = ab > O.where k* is defined in Proposition3. fi < k.G(k)). if (Wd. As in the case of the firm. It is worthnoting that the proofof Proposition4 establishesthat the optimal k (or k's if there is more than one) is independent of U in the exponential case. Furthermore. Proof. Callthis E.it is optimal for the firm to offer the workersomething This it does by settingk close close to completenet incomeinsurance.

&is replaced by (9 + a) and R by (R + a). Proof. Proposition 7 says that the same is true under asymmetric information. w = wu. the maximum increase in the probability of unemployment relative to the Walrasian case.e. we have 8. In the case of symmetric information the probability of unemployment = prob(9 < R) is unchanged by this. where a > 0. Under asymmetric information.4 > 0 such <? that if (-V"(7r)/V'(7r)) > a for all ir and (-U"(x)/U'(x)) for all x. where a > 0.k + a) will be an optimal contract after the change.2)-(2. any optimal contract has the property that Ik . Then. Under symmetric information this will lead to a lower probability of employment. k < k.. the probability of unemployment can lie anywhere between G(R) and G(k). the probability of unemployment = prob(g < k) will not change. PROPOSITION Let the firm's utility function be given by V(ir) = -ebr and the worker's by U(w) = -e-aw. Q. i. if (w>. How CHANGES IN THE DISTRIBUTION FUNCTION G AFFECT THE PROBABILITY OF UNEMPLOYMENT In the last section we considered comparative statics with respect to a change in the firm's and worker's attitudes to risk. Consider first what happens if there is a uniform shift to the right in the distribution of s. 7.140 QUARTERLY JOURNAL OF ECONOMICS optimal contract. depending on how risk-averse the firm and worker are. there exist a. Proof. (2) given E > 0. However. See Appendix. problem (2. PROPOSITION Assume (A1)-(A3).4) remains the same. It tells us that. (w>. Let the random variable &be replaced by (&+ a) and R by (R + a).k < E. which can be explained by the implicit contract-asymmetric information theory. In particular. We consider now what happens if there is an increase in R. If we substitute R' = R + a.2)-(2. Proposition 6 is useful if we know the distribution function G but do not know the form of the utility functions U and V. and R increases by the same amount. Let R . given G.D. but s stays the same. &' = s + a. where ab > 0.E. it appears difficult to say what will happen in general. is G(k) - G(R). In particular. IV. if U and V are exponential.k) is an optimal contract initially. k' = k + a in (2. We now analyze the effect of changes in the distribution function G.4).

the probability of unemploymentstays the same. Now reduceR by a.is also multiplied by A.This means that all productionactivities (including the opportunitycost of laborat date 0) are scaled up or down by the same amount. Q. i.e. k falls.. Then. respectively. (wtI') are optimal contracts. we must have I' < (I + a). Proposition 9 says that the same is true under asymmetric information in the case where U exhibits constant relative risk aversionand V(r) .E. Consider the problem.e. AXR. and irobe replaced by As.Then if (wi.if s < R.the latterif it is the logarithm . I' <I + a. the probabilityof unemploymentfalls. givenby (A3).e.-we get immediately the following corollary.IMPLICIT CONTRACTS UNDER ASYMMETRIC INFORMATION 141 be replaced by (R + a). where a. See Appendix. where a > 0. I' > I.I) is an optimalcontractinitially./). (AWuA) is an optimal contractafter the change. b COROLLARY. Proof. Airo. ifs < R. Proof. Propositions7 and 8 are concernedwith additive shifts in s and R. We next considerthe case of a multiplicativeshift. where X > 0. w. if ( W>.Let the firm's utility function be given by V(r) == -e-aw. we suppose that s and R are multipliedby X > 0. Furthermore.W(ro + ir). Under symmetricinformation. we must have iP'> i. Suppose that s and R both increaseby a. Let s. before and after the change.. (dP. R.the probabilityof employment is unchangedby this. Then. if (Wu.2) subject to (2. or W(XAro XA7r) 0(X) + W(iro+ 7r)(the former holds if W(ro + ir) is a powerfunction. + Under constant relative risk aversion. Assumethat (A1)-(A3) hold before and after the change. AR. i. where a > 0.i. respectively. before and after the change. If we combine Propositions 7 and 8. where W exis hibits constant relativerisk aversion. Proof.D. Furthermore. Then we know by Proposition 7 that k increasesby a. and that w-. Then.Let s be reand the worker's by U(w) placed by the random variable (&+ a). either W(XAro Air) = = + 0(X)W(iro+ -r). the probability of unemployment rises. PROPOSITION Supposethat U(w) exhibits constant relative risk + aversionand that V(ir)can be writtenas W(7ro ir) for all ir for > some 7ro 0.. by Proposition 8.In particular./i') are optimal contracts.b > O. 9.u).as long as 7ro also subject to the scaling effect.maximize (2. where W also exhibits constant relative risk averand sion.3).

Then under symmetric information we get em- .E.1) h is the smallest value of k that maximizes (k .G(k)).e. If SL ? R < SH. the only interesting case is where R < SL < SH.2)-(2. 7rL > 0. An illuminating special case is where s can take on only two values. where rL + 7rH = 1. then Proposition 1(1) tells us that employment will occur if and only if s = sH. i. Q. but this will not matter for what follows.142 QUARTERLY JOURNAL OF ECONOMICS function). V. V' = XaJ. This case violates our assumption that G has a density function. the firm cannot pay the worker a positive wage when it does not employ him. where (5. if iro = 0.D. In the next section.. It follows that when s can take on only two values. it appears difficult to establish further results about the behavior of k as a function of the distribution function G. The same is true for U. SL with probability WLand SH with probability 7rH. In this case. In particular. wi = Xwn. parts (1) and (2) of Proposition 1 continue to hold (see Remark 1 of Section II). It is then quite natural to scale iro by X too. as we noted in Proposition 6 of Section III. The best way to think of wo is as the output (revenue) of the firm coming from sources other than the worker's production. Therefore. &' = As.R)(1 . the optimal k will be close to k. THE CASE WHERE THE FIRM IS EXTREMELY RISK-AVERSE AND THE WORKER IS APPROXIMATELY RISK-NEUTRAL In the last section we obtained some results about how the probability of unemployment is affected by changes in the distribution function G. It follows that if we substitute R' = XR. however. we shall show that some results can be obtained for the case where the firm is extremely risk-averse and the worker is approximately risk-neutral. In this section we obtain some further results for the case where the firm is extremely risk-averse and the worker is approximately risk-neutral. we see that there is no difference between symmetric and asymmetric information. The reason for introducing ro is that constant relative risk aversion utility functions are defined only for nonnegative wealth.4) remains the same. Since this employment rule is also optimal under symmetric information. k 2 SL. k' = Xk. problem (2. In general. and xH > 0.

then every optimal contract (-U"(w)/U'(w)) . the two cases yield profit for the firm in the worst state of (SL . (k) at the point k = SL.e. w>(k) is decreasing in k. respectively. (limk+SLWU (k) > wI (SL)). there exist a.SH. as defined in (3. to set k = SH. We therefore have as a special case of Proposition 6: PROPOSITION10. G(s) = 0 for 0 < s < SL.R) and (.R): = UU(i) if k =SL (5. It is possible to have either wu(sH) > Wu(SL) = (W + R . Note that there is a discontinuity in w. G(s) = 1 for s > SH. If R < SL < SH.IMPLICIT CONTRACTS UNDER ASYMMETRIC INFORMATION 143 ployment in both states.V satisfy (A1)-(A3) and (-V"(7r)/V'(7r)) > a for all ir. Thus. V.G(k)) is replaced by prob[9 > k]).)Furthermore.. from which it follows that the optimal contract will involve unemployment when the firm is infinitely risk-averse and the worker is risk-neutral if (5. if (5. As in Proposition 6 this is also a necessary and sufficient condition for unemployment to occur in the bad state for some utility function U.3) holds.SL) or Wu(SH) < Wu(SL).Thus.(k))7rL =U ifsH>k>SL- As noted in Remark 1 of Section II. where R < SL < SH. In the first case k = SL and the worker's wage when employed is w + R (see (5. The optimal contract involves either employment in both states or unemployment when s = SL. whereas under asymmetric information we may get unemployment when S = SL (note that we shall always have employment when S = sH-see Proposition 1). Consider an infinitely risk-averse firm and a risk-neutral worker. in the discrete case. G(s) = 7rLfor SL < s < SH.1).aT.-J.3) holds./ > 0 such that if U.R. In the second case the worker's wage when unemployed = Wu= H(k -R). the firm's profits in the worst state are SL . Except for the discontinuity. that is. <? for all w. Suppose that &takes on just two values-SL . wU(k).R)). It is easy to show that Proposition 6 continues to hold in the discrete case (where (1 . If the firm is infinitely risk-averse. it is obviously optimal to maximize k. i.2)). Then a necessary and sufficient condition for there to be some UV satisfying (A1)-(A3) for which there is an optimal contract (wuk) with k > SLis that (5.2) U(wu(k) +k-R) U(wu(k)+k-R)7rH+U(w. is given as follows for SH > k ' SL = max(SL. s = k is always considered an employment state when k > R. (k > SLmeans that unemployment occurs in the bad state s = SL.a7 + 7rH(SH .3) SL -R < rH(SH R).

(SL . Suppose that we keep (SH . and this is very important to a highly risk-averse firm even if the probability of s = SL is low. The probability of unemployment will then be rjL.G(k))+ denotes the probability that s > k. It is clear from Proposition 10 that in the two-state case Propositions 8 and 9 generalize to the case where the firm is extremely risk-averse and the worker is approximately risk-neutral.Then we know from Proposition 10 that. Note that in the limit when 7lL = ((SH ((SH .SL)/(SHextremely risk-averse firm and an approximately risk-neutral worker. . The probability of unemployment reaches its supremum as rL . V.3) tells us that unemployment is more likely to occur in the bad state (A) the lower is the probability of the bad state. if the firm is extremely riskaverse.144 QUARTERLY JOURNAL OF ECONOMICS satisfies k > SL.3) holds initially.3) is unaffected.1). if (5. an increase in rTL reduces the probability of unemployment. the relationship is not monotonic. ConR).SL)/(SH SL)/(SH . Clearly.G(k))+ (see Proposition 6) is maximized at both k = SL and k = SH-18 That (k . as shown in Figure II. (A) and (B) are fairly intuitive.3) will hold for all irL < (SH . Similarly. the gain from improved risk sharing may be large.G(k))+ has two maxi18. (k . if (5. unemployment will occur for some U.R)). the expected efficiency loss that results from making s = SL an unemployment state is small. Condition (5. given an dition (5. In contrast. Thus. (1 . then it will continue to hold if R increases. after a certain point.R) is small. if k satisfies (5. For if (5. Proposition 10 also enables us to determine for what two-point distribution the probability of unemployment will be highest. In particular. the probability of the bad state. since we switch from the regime in which s = SL is an unemployment state to the regime in which there is employment in both states. If 7rL or (SL . approximate versions of Propositions 8 and 9 can be established for the many-state case when the firm is extremely risk-averse and the worker is approximately risk-neutral.R)(1 .R) constant and vary rjL. (B) the lower is the net social return in the bad state relative to that in the good state.3) holds and the firm is sufficiently risk-averse and the worker is approximately risk-neutral. we have a relationship between the probability of unemployment and 7rL.R)(1 . then an increase in R can be shown to reduce k. while a proportionate change in s and R will lead to the same proportionate change in k. In particular.R)).3) holds. This is because by making s = SL an unemployment state the firm is able to reduce wages in this state. if SH. In fact. then (5. SL and R are all increased by the same proportion.R). unemployment will occur when s = SL. That is.

< sn. ..7r?) = (S3-R)(1 . Thus. Proof. under the conditions of Proposition 11. Note that by regarding s1.si)/(sn .. the maximum probability of unemployment when both ir and the risk aversion of the worker and firm are variable is (Sn . Let G (x). ..Si)/(Sn . This shows that. < * < sn. with each si > as R. PROPOSITION 11. the limiting distribution in which G (k)... the probability of unemployment tends to one in the former case.INFORMATION145 IMPLICIT CONTRACTS UNDER ASYMMETRIC Probability of unemployment SH-SL SH-R A450 SH-SL 1 7L ~LSHR FIGURE II miners is no coincidence. .R) = (s2 ...4) (s.1)... there is no limit to the amount of unemployment which can be explained by the implicit contract-asymmetric information model relative to the implicit contract-symmetric information model.. with probabilities 1.R)(1 . where k is given by (5. . Suppose that s can take on n fixed values s1 < S2 <. if the distribution function G can be chosen arbitrarily.R) lsi>k - 0}. the probability of unemployment. we can make (Sn .R) and in the limit 7r?.R)(1 - = {7rERn 1l ri = 1. has a supremum equal to (Sn . while it equals zero in the latter case..R) as close to one as we like (simply let si R). then. For each vector of probabilities 7r = imize (h G(k(r))-= (Tro.. .r > G(k))+ . Urn.EA (sn - si)/(sn R). The next proposition shows the following: if s can take on n values s..7r-ir0) (sn -R)nr. In other words. respectively.G (k)-. . . where each si > R. .(k .sV)/(sn .irn ) EAn . For as s1 R. ir satisfy (5. sn as well as 7r1...G(k))+ is constant for k equal to the mass points of s. letk(7r) maxiri.R). . rn as variable."achieves" the supremum has the property that (k .be the probability that s < x. . See Appendix. If we return to the case where s takes on two values. we can also . .R)(1 . if we regard the wri's variables. Then sup. .

R and so if p is not observed. for each p. Now suppose that p is observed and 70OH= 3/4.irL. Ceteris paribus. SL = 4. A contract now is a vector (wu(po).Then lrH(SH . Assume now that at date 1 the worker or receives a signal p about s. In particular. the probability of unemployment is zero if the firm is sufficiently risk-averse and the worker is approximately risk-neutral. Suppose again that s = SH or SL with probability irH.R.146 QUARTERLY JOURNAL OF ECONOMICS use Proposition 10 to obtain some negative results.k(pi)). It follows that if the firm is sufficiently risk-averse and the worker is approximately risk-neutral.R = wu = the wage in unemployment states). to one.R) > SL .R) < SL . and Xo = X = 1/2. where7rL is close S = SL. prob[s = SL IP = Pi] = (WTiLWrL)/Xi.wu(p1). 7T1H = 1/4. respectively. 71L = 3/4.R when *L is close to one. For similar reasons. 7rHSH + 7rLSL =7= 7rHSH + 7LsL. and so this corresponds to a mean preserving spread in the sense of Rothschild-Stiglitz. the desire to shed risk will be greater for the firm the riskier is profit when k = R. SL = 6. and 7rL = 1/2.Then lrOH(SH . which is common knowledge. SL <SL.O) may lead to an increase in k and possibly to an increase in unemployment. suppose that SH = 10. Using Proposition 10. We have seen that increases in k allow the firm to transfer some of the risk it is bearing to the worker. it is not true that an improvement in the worker's information about s necessarily leads to an increase in the probability of employment. the firm is bearing all the risk and the worker none (the wage in employment states = wu + k . for when k = R.R) < SL . and that the conditionalprobabilitythat p = pi given s = sH is lriH and that p = pi given s = SL is 7riL. Then 7rH(SH . and so now there will be full employment for all utility functions U. one uses the posterior probabilities prob[s. V. R = 0. assume that p = PO P1. This suggests that an increase in the riskiness (in the sense of Rothschild-Stiglitz [1970]) of "first-best" profit or net social return max(9 . Then SH > SH. However. to compute expected utility. In particular. where now. there will now be unemployment when p = po in the state s = SL. we may easily construct examples in which the probability of unemployment rises as a result of the signal p being observed. however. AH(sH . . This is not true in general. where Xi = prob[p = Pi= 7riH-H + lriLlrL.R. let R = 0. there is unemployment when SL = 33/4. where 7rOH+7rlH = rOL+lrlL = 1. and 7lH = 7L = 1/2.SH= P = Pi] = (wriHw7H)/Xi.R.R) > SL . To see this. An optimal contract is defined in the obvious way. and so if the firm is sufficiently risk-averse and the worker is approximately risk-neutral. since wages can be made to depend on p.33/4 rL)/( -lrL).7TH = 1/2.k(po). 7TOL= 1/4. SH = 10. Now let SH = (7 .

The . employment is a good instrument for inducing incentive-compatible risk sharing.G). Thus. which yields the firstorder conditions. (5.G(k)). VI. However a contract which specifies that the wage bill is an appropriately increasing function of total employment can induce the firm to cut wages only when &is low.R)(1 .5) k-R = (1 - G(k))/G'(k). When &is not observed by workers. CONCLUSIONS This paper has been concerned with analyzing the implications of the assumption that a worker's marginal revenue product &is observed by the firm but not its workers. on how it affects the hazard rate G'/(1 . optimal risk sharing requires a fall in the firm's wage bill when &is low. This is because a drop in employment makes the firm bear a cost of decreasing the wage bill that is high in states where &is high and low in states where ? is low. increases in riskiness and improvements in informativeness do not generally affect the hazard rate in a simple way. For then we move from the case of asymmetric information to the case of symmetric information and the probability of unemployment must fall (or stay the same). the wage bill cannot be made an arbitrary function of the true ?. Unfortunately.IMPLICIT CONTRACTS UNDER ASYMMETRIC INFORMATION 147 Of course. among other things. Then k maximizes (k . This is true for a number of well-known distributions such as the normal (see Barlow and Proschan [1975]). Clearly how a change in the distribution function G affects the probability of unemployment will depend. The right-hand side of (5. the above cannot happen if the signal p gives perfect information about s.5) will have a unique solution if the hazard rate is increasing. We have been concerned with analyzing what determines how much unemployment the asymmetry of information between firms and workers can cause in situations where labor supply is inelastic (over the region where wages exceed the reservation wage). In a world where &is common knowledge. Further insight into why increases in risk or improvements in information do not have unambiguous effects on unemployment can be obtained by returning to the general case where there are many states. since workers cannot determine ?. If the firm's owners are riskaverse.5) is the reciprocal of the hazard rate of the distribution G. this need have no implication regarding employment (especially if labor supply is inelastic). Equation (5.

148 JOURNAL OF ECONOMICS QUARTERLY benefit of unemployment is that the firm is able to reduce the wage bill in bad states and hence to bear less risk (the worker correspondingly bears more risk). Even if the firm uses an insurance company to achieve risk sharing. the more risk-averse is the firm and the less risk-averse is the worker. By "unemployment will be higher. and (2) that the only variable which is common knowledge is employment. they are risk-averse. As a result. The difficulty in generalizing the comparative statics results of this paper to the case of many workers stems from the fact that. the insurance company unable to observe s would find it in its interest to condition income transfers on the level of employment. i. If s could be observed by the market.e. As we showed in Section III. In Grossman and Hart [1981]. gross profit s is not common knowledge. in particular. The cost of unemployment is that it is ex post inefficient. if workers can observe the employment level in the firm. we showed that if L can take on any finite number of values. Note that once s is unobservable. variations in productivity s (in the region where s > R) will lead to variations in employment under asymmetric information. this suggests that the optimal amount of unemployment will be lower the smaller is the probability mass of states close to R.. the wage function can no longer be represented by just two numbers-a wage when employed and a wage when unemployed-as in the one-worker model. however. Since the benefits in terms of risk-sharing are unaffected by the magnitude of (s . and thus unemployment will be higher. which showed that a shift in each s from s to s + ax. benefits from risk sharing will be higher. It is intuitively clear that the cost of introducing ex post inefficient unemployment in state s is smaller the closer the state is to R. reduces the probability of unemployment. then the owners of the firm could condition income transfers directly on the realization of g. then our implicit contracts model implies that there will be less (or the same) employment in each state than there would be in a spot market model (with employment being equal in both models in the best state of nature). In this paper we have concentrated on the case where L = 0 or L = 1.19 Our analysis makes two important assumptions: (1) that the owners or managers of the firm are unwilling to bear all of the profit risk associated with variations in s. .where ax> 0. but not the employment level in the firm as a whole. Note that all our results generalize to the many-worker case if each worker can observe only whether or not he is employed." we mean that even though labor supply is inelastic under symmetric information (over the region where wages are larger than the reservation wage R). This was made precise in the Corollary to Proposition 8 in Section IV. 19. wages can be conditioned on this variable. employment is a useful screening device for any party that the firm wishes to share risk with.R).

An essential feature of our theory is that there is an asymmetric response to productivity shocks. We wish to argue. Note that under these conditions.IMPLICIT CONTRACTS UNDER ASYMMETRIC INFORMATION 149 The assumption that owners are risk-averse and profits are not observed does not seem unreasonable for the case of small ownermanaged firms. In particular. a moral hazard arises with respect to the bad states of nature because it is there that the firm asks workers to take a wage cut (the firm would always claim the state is bad if there was no accompanying employment reduction). when s is high.. for example. involve the manager holding a significant fraction of the firm's shares. A formal model along these lines is developed in Hart [1983]. Then in order to induce the manager to take the right actions. the moral hazard problems discussed in this paper remain. Consider a corporation that is run by a manager who takes actions which the owners cannot observe. while it can be shown that in an optimal contract wages will now be conditioned on profits as well as on employment. the manager will have no incentive to manage the corporation well and the incentive scheme will be self-defeating. that our model. profit)-such an incentive scheme may.g. the owners will prevent the manager from diversifying (assuming they can monitor this).e. however. ex post profit. It is less reasonable as a description of public corporations that publish profit statements and pay dividends. it will still be the case that the firm will have to create too much unemployment (from an efficiency standpoint) in bad states in order to show workers that times really are bad. and where owners can diversify away risk through the stock market. the firm can always increase wages to get more employment and better risk sharing. it is an endogenous variable like employment. As a result. i. There is no moral hazard . V refers to the risk aversion of the manager. even if observed. will not be a perfect signal about the firm's performance. Under this interpretation. Obviously if the manager can then diversify away risk by selling off these shares. applies to this case too. under certain assumptions our underemployment result can be shown to generalize.. i. the owners will give the manager an incentive scheme that makes the manager's utility depend positively on the firm's performance (e. the owners and the manager are in a principal-agent relationship. and this can be achieved in an incentive compatible manner only if it is accompanied by a decrease in employment. However. Thus. with some modifications.e. To put it differently. since profit depends on unobserved actions of the manager. Thus.. When s is low. which means that the manager will be risk-averse with respect to the firm's profit stream. optimal risk sharing implies that there should be a cut in the wage bill.

As a consequence of this.Walrasian levels of unemployment. and this leads to labor supply fluctuations. In our model this is not the case. Lucas [1972] proposed a model where short-run labor supply depends on the expected interest rate (which in his model is the real return to holding money-the only asset in the model). the driving variable that converts long-run inelastic labor supply into a short-run elastic labor supply is a variable like x . Good states lead to Walrasian levels of unemployment. In a model of relative demand shocks across industries. and Maskin [1982] develop a general equilibrium model of implicit contracts in order to explore the above asymmetric effect. we were able to show that the level of employment under asymmetric information equals the Walrasian level in the best state of nature. labor supply is a linear function of the difference between the expected economy-wide price level and the actual price level: L (E [PI Info] . there are versions of Lucas' model where the driving shocks are real (not nominal) and the inefficiency in output also depends on expectational errors. Grossman. there is no reason (or emphasis in the logic of the theory) for L (-) to respond in an asymmetric way: agents make "up side" and "down side" forecast errors.20 In all of these models this is a symmetric variable. Hart. For example. In linearized versions of Lucas' [1972] model such as Barro [1976]. while bad states lead to non. The fact that in our model bad states create non-Walrasian unemployment but good states do not create non-Walrasian employment suggests a method for distinguishing our theory from some other asymmetric information theories of employment. It is at the very essence of the model that labor supply response is asymmetric. Workers in a particular submarket have incomplete information about the real interest rate. Grossman and Weiss [1982] considered a model where there are real productivity shocks and employment is a linear function of the difference between the observed productivity r and the anticipated real opportunity cost of investment: L(r .E[r Iinfo]). A model where the relative demand shocks are caused by wealth re20. . Workers in all submarkets make correlated errors in forecasting interest rates because they all condition their forecasts on the observed price level in their submarket which is in turn affected by the economy-wide money supply. Though Lucas [1972] and Barro [1976] consider models where "inefficient" unemployment occurs because of monetary nonneutrality.150 JOURNAL OF ECONOMICS QUARTERLY with respect to the best state of nature because the firm would never claim that times are very good and give workers an increase in pay if this were not truly the case.P). the above asymmetry implies that relative demand shocks decrease employment by more than they would under complete information. Further. In particular. In all of these Lucas-like models.E [x IInfo].

Suppose that Eg(U(X1)) < Eg( U(X2)).k. defined bygx (U) = Xg(U) + (1 . i. that under (wuik. (W/k) is never chosen.e. respectively. and that a risk-averse person with U'(x) > 0 weakly prefers X1 to X2./') to (Wuk).e. Suppose that Xl(s) and X2(s) are fuietions of s. and assume that F2(x) # Fi(x) for some x. Let F2 satisfy the single crossing property with respect to F1. the individual with utility function g-X(U) is indifferent between X1 and X2.) on the whole real line. . But this means that whatever V is the firm will prefer (Wu. That is. X2 is riskier than X1 in the sense of Diamond-Stiglitz [1974]. APPENDIX Proof of Proposition 2: Step 1.F2(x) > 0 for x > x0. Proof of Proposition 2: Step 2. since an individual with utility function g1(U) is more risk-averse than an individual with utility function g-x (U).D.wu . the individual with utility function gl(U) must prefer X1 to X2. Hence wu > dU. by continuity there exists X such that Egx-x(U(XD)) = Eg-x(U(X2)). define F1(. EU(X1) > EU(X2). However.wu) is lower for small s and higher for W- . wd <iWU <iWU+ k' <Wu+ k. say F1(-) and F2(-). Our proof will involve the use of the following lemma.i. It follows that. We shall sometimes say that X1 is less risky than X2 in the above case. Suppose that k' < k. Consider a person more risk-averse than person U in the sense that the new person's utility function is g(U(x)). A similar argumentshows that Wu+ k' < wu + k. Note first that it is im+ + kI. Therefore.which means since then wU. Since Eg1(U(X)) < Eg1(U(X2)) and Ego(L(X1)) > Ego(U(X2)). and hence there are more employment states under k'. Q. Consider the class of concave transforms gx (-). in view of the single crossing property. X2(s) be real-valued functions of s. Eg(U(Xl)) > Eg(U(X2)).. We do not require that EX1 = EX2. The distribution function of s induces distribution functions on X1 and X2. 0 < X < 1. strictly concave function. kI'< possible to have U < w'U. that is. Contradiction. where g(-) is a strictly increasing. But this means that the firm's net profit max(s . LEMMA 1. Then Eg(U(X1)) > Eg(U(92))Proof. Let Xi(s).IMPLICIT CONTRACTS UNDER ASYMMETRIC INFORMATION 151 distributions associated with unanticipated movements in the price level leads to implications that are very different from those of Lucas-like models of the same phenomenon.) the firm pays less both when the worker is employed and when he is unemployed.X)U for all U. We say that F2 satisfies the single crossing property with respect to F1 (written "F2 scp F1'")if there exists an x such that < 0 for x < x0 F1(x)-F2(x) F1(x) .E. For convenience..

since otherwise k (a) would not be preferred to k*. for a large. Hence k < k*. It follows that the distribution of max(s ./k) to (KIk). This proves that k' > k. a firm with utility function V prefers k = k (a) to k*.2)-(2. Q. while the third term goes to positive infinity.E. Using the argument of the proof of Proposition 2. We have shown in Section II that k < k*. - . and so k = k* does not satisfy the first-order conditions for problem (2. -K u) satisfies the single crossing property with respect to the distribution of max(s By Lemma 1. Let Ii infix Iprob(Ii < x) LEMMA2. which says that. this contradicts the fact that a more risk-averse firm (weakly) prefers (A. then he will always choose the gamble with the higher minimum value. suppose that it is false. again by the proof of Proposition 2.. Now dwu/dk = -RHS of (2. Then. By definition. Let I.W'k'. EV(11) < EV(I2). To establish the last part of the proposition. and I2 be two functions of s that are bounded above by a number b.5) = 0 at k = k*. . the left-hand side of the expression is positive. one shows that k' = k violates the first-order conditions (2. Q. Suppose that I < 12. -w4) - max(s - . i.2.D. w- k'.EV(I1)je+a2 =-E =-Ee-a(I2-2) + [e-(I2'2) b I2 - e-(I1'2)] e-a(I1-I2) dF + 1 e-a(I1-I2) dF. a firm with utility function -e-at prefers the profit stream with the higher value in the worst state. As a goes to infinity.E.e.D.E. the first two terms are bounded. But LHS of (2. We show that if a person has constant absolute risk aversion of a sufficiently large size. if a is sufficiently large.- k. U A Proof.4). We shall need the following lemma.Ik) and a less risk-averse firm (weakly) prefers (i. Hence. the firm's profit stream when k = k (a) will satisfy the single crossing property relative to the profit stream when k = k*. we may conclude that wu(k*) < w (k (a)) < wu (k (a)) + k (a) < wu (k*) + k*. Note that as a a ). kI') to (i . Proof of Proposition 3: Step 1.5) > 0. It follows from Lemma 1 that a firm with utility function -e-a will prefer k = k (a) to k = k*. -wu) is negative for s < some s* and positive for s > s*. Then we can find a sequence of optimal k (a) converging to k < k* as a a) . But this contradicts Lemma 2. To prove (2). Q. Wu (a)) (k wu (k) > wu(k*). Proof of Proposition 3: Step 2. {EV(12) .5). Therefore.D.152 QUARTERLY JOURNAL OF ECONOMICS large s under (dIP) u(s) max(s - than under (&. Suppose that V(x) = -e > 0 for i 1.I). for a sufficiently large.

a) -*wh as a if k is bounded away from max(s. Q.R).e. WU + k . Consider (2.1). wu (k. It is easy to see that WU is decreasing in k and (wU+ k) is increasing in k. Note first that k is by construction the smallest value of k that minimizes wu(k).. The next point to notice is that we can equally well think of an optimal contract as maximizing the worker's expected utility subject to the firm's expected utility being equal to some V (V of course depends on U). This proves that k(a) . the worker is very risk-averse. Assume that k' > A. wu + k . It follows that the optimal k is independent of U in the exponential case.s + R satisfies (2. i.3) for all utility functions U.e.R when employed) is riskier in the sense of the single crossing property when k = k' than when k = k.max(s.3) for all utility functions U.e.D. The above argument shows that in the exponential case the optimal k will be independent of V.. In particular. (k). the workeris risk-neutral. That A'< k if s < R follows from the fact that A'= k is not consistent with the first-order conditions (2.R).with certainty (see o a.(k ') < w. Hence k' > Aimplies that a.IMPLICIT CONTRACTSUNDER ASYMMETRICINFORMATION153 Proof of Proposition 4. It follows that A' ? k. Substituting in (2. i.R with probability (1 . wu(k) must be close to w-for the worker to (k) be indifferent between the lottery (wu(k) with probability G (k).3).R) as a -a co. Clearly the firm could do better by setting k = max(s. by Lemma 1. Hence fix V and let the worker become more risk-averse.E.. defined in (3. If k = R. to prove part (1). Proposition 4 does not appear to hold for general utility functions. i. Q. for the case where U is linear. One proceeds as in the proof of Proposition 3. the worker's net income (wu when unemployed. the firm pays in the limit hi when the worker is unemployed and more than (h + R) when the worker is employed. where k* is defined in Proposition 3.E. to express wUas a function of k: wU = vu(k). where 0 is a function of k. If k = s > R. Proof of Proposition 5. Take k > max(s.G(k))) and w. this can be written as e-alwuq(k) = U.(k) < tu (k)+ k < Cvuk') + A'. But this means that Lemma 2). then wu = W. it is enough to establish that k* < k when U is nonlinear. Then the worker's net income is w (k) < w if unemployed and wu(k) + k . The proof breaks down because V changes when the worker becomes more risk-averse and the optimal k is not independent of V. Then wU(k*) < w. Proof of Proposition 6.(k). In the exponential case. (A. Therefore.5)..R). In both cases the worker'snet income is ff with probability 1.2) yields an objective function for the firm of the form U(-b/a)4.Use the equation. where wu refers to the nonlinear utility . In view of Proposition 3. When a is large. This contradicts the fact that the worker prefers k to k' when a = ao and A'to k when a = a. then wu = w-satisfies (2. Suppose that k* > k.1) f V(s-kw-u) dGJ+ V(-wU) dG = V.R if employed. increase a.D.

Hence k < Sn. Q.R).Si)/(Sn . suppose that it does.k) > EU(R + ak') given that k > k'. w (k) + k .G (k))).R)(1 -G(k*)) > wu(k)G(k) + (wu(k) + k - R)(1 -G(k)) which implies that (k* . it follows that EU(R + a. weLk*) + k* -R with probability I . it follows that OEU/IR is larger the larger is k (since (ith Ck) + k) is increasing in k). But then (k . we must have -rn < (s . Thus.2) with respect to R.G (k*)) > (k .. To show that the probability of unemployment cannot exceed (Sn . To prove (2). since (k . we may think of the optimal contract as maximizing the worker's expected utility subject to the firm's expected utility being at least V. But this means that L1 is riskier in the sense of Diamond-Stiglitz [1974] than L2. That the same is true if the worker is approximately riskneutral follows from a continuity argument.S)/(Sn .k I < e. The latter constraint may be used to solve for wu = Jv (k). By choosing 7rclose to the 7r.k) __5_R_ = -U'(vu (k) + k - R)(1 -G (k)). (k*) with probability G(k*).3) (R.k) = U('u(k))G(k) + U(wu(k) + k - R)(1 - G(k)).D.4). it follows that w. note that if the worker is risk-neutral.e.R)(1 .ik) ' EU(R. Proof of Proposition 11.R).R with probability (1 . From this. Proposition 3(2J tells us that there exists a such that (-V"(w )/V'(ir)) > a ==k . But this contradicts the fact that I' is optimal under This proves that I' ' I. Finally. k < sn-1. where Cvu is decreasing in k and (vu (k) + k) is increasing (k) in k. Hence we may write the worker's expected utility as (A.R). we can ensure that (k .which solves (5. Since the probability of employment is lower under L1.7r?) = (Sn .R)(1 .R).( . .R)(1 = G(k)) is greater at k = s1 than at k = Sn. This contradicts the definition of k.R). wu(k*)G(k*) + (wu(k*) + k*. This yields (A.G(k))+ is maximized at k = Sn. Proof of Proposition 8.5). As in the proof of Proposition 4.E. for the probability of unemployment to exceed (Sn .2) EU(R. the probability of unemployment can be made arbitrarily close to (1 .R)(1 . I' = fIviolates the first-order conditions (2. (k*) + k* . Note that by Proposition 1(1) we always have employment when s = Sn.R)/(sn . Since we know that EU(R.154 QUARTERLY JOURNAL OF ECONOMICS function U.k') (I is initially optimal). This shows that employment will (R+ a). Thus. Suppose that k' < k.Si)/(Sn .G(k*))) and the lottery L2 = (wa (k) with probability G(k). i. and so a risk-neutral worker will prefer L1 to L2.R > wu(k) + k .R. Therefore. But this means that a risk-averse worker with utility function U is indifferent between the lottery L1 = (w. Differentiate (A.G(k)) cannot reach a maximum except at a mass point.G (k)). since wu(k*) < wu(k).

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