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: . Accessed: 15/06/2011 15:56
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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.


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



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].

In one (the "variable wage-fixed employment" contract). but agree to take a wage rate cut in bad states of the world. . where average truthtelling cannot be verified over a long period. however. This problem will be less serious if workers can observe variables that are correlated with the state in this firm. in the long run workers will be able to verify the truthfulness of the firm's announcements. Workers can observe immediately whether the firm deviates from an announced wage-employment schedule w(l) to be defined below. In general.g. This is because its wage-employment implicit contract is defined in terms of quantities that are immediately observable.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. 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.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. even though the contract may specify that wages should be high in good states and low in bad states. Each of these contracts permits the wage bill to vary with s and shifts some of the risk from the firm to the workers. However. Our results should. 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. even if s is correlated over time or the discount rate is positive (so Radner's result would not hold).. assume that the firm is risk-averse with respect to its profit stream (In Section VI we provide a justification for this. the state in the industry as a whole. however. there is no clear reason for the workers to prefer one type of contract to the other. actual wages will always be low. Thus.In particular. however. For then workers need only check that the firm is telling the truth on average. In particular. if only the firm can observe the state. since this allows the firm to reduce wages without sacrificing employment. given the "variable wage-fixed employment" contract. In the other ("fixed wagevariable employment"). Consider two different contracts that the firm might offer its workers. Matters change considerably. It might be thought that. workers are guaranteed a particular wage rate but may be laid off (or made redundant) in bad states. workers are guaranteed employment. In this paper we shall study a "one-shot" situation. since the implicit contract model is based upon the idea that firms establish reputations. To understand the basic issue. For then the workers must rely on the firm to tell them which state has occurred. Thus. firms can develop a reputation for their wage-employment policy. its wage bill must be low when s is low. the firm may wish to misreport the state. the "fixed wage-variable employment" contract is 4. it is always in the firm's interest to claim that a bad state has occurred. e. This means that its wage bill must vary with &. this requires stronger assumptions than are necessary for the firm to establish a reputation about layoffs. In a world where both the firm and the workers observe the state ex post. and so the "variable wage-fixed employment" contract becomes a "fixed (low) wage-fixed employment" contract. See Radner [1981].

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

his utility is U(W'). Consider a (representative) firm that can employ at most one worker. (respectively. The paper is organized as follows. In Section II the model is described.IMPLICIT CONTRACTS UNDER ASYMMETRIC INFORMATION 127 as the firm's risk aversion. the workers' risk aversion. W') is the worker's wealth when employed. Finally. In Sections IV and V we consider how unemployment is affected by changes in the probability distribution of the marginal product of labor. Let G be the distribution function of s. and employs. and if he is unemployed. 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.R). which is positive for s < s < g. Here R represents the worker's . In Section III we analyze how unemployment is affected by changes in the risk aversion of the firm and worker. 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. a single worker. We shall therefore simplify matters considerably by confining our attention to the case where a representative firm makes a contract with. and perhaps other variables too.We assume that G has a continuous density function g(s). but not how many other workers are employed by his firm. Each worker has a von Neumann-Morgenstern utility function U. If employed. are observed by the workers. his utility is U(W . 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. This is obviously a very special case. 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). the workers' reservation wage. the productivity of labor. If the worker is employed. 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. THE MODEL The model is based on that of Grossman and Hart [1981]. G (s) = 1 for some s < s-. where W (respectively. unemployed). All potential workers are assumed identical. II. the output or revenue (we shall not distinguish between the two) of the worker is given by the random variable s. concluding remarks appear in Section VI. We assume that G (s) = 0. etc.

the worker is unemployed. We shall suppose. 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. We shall call R the worker's reservation wage. if we assume that a contract has been signed.. but that cannot readily be transferred to other firms. The only effect this has is to increase the effective opportunity cost of labor or reservation wage from R to (R + R'). it is the amount that he must be paid to compensate him for working. the worker is employed. At date 1. The worker. however. G is known to both parties. . (We also assume that U. or to put it another way. See Section VI and footnote 4 for a motivation for the asymmetric information assumption. and R are known to both parties at date 0. It is also assumed that if the worker signs a contract with this firm.8 Thus. 7. his productivity elsewhere is zero. at date 0. the firm decides whether to sign a contract with a worker. that at date 1. production and employment can occur. Finally. V. If production does not occur. The contract will specify under what conditions they will occur. the firm and worker have symmetric information. he cannot work anywhere else at date 1. If production does occur at date 1.128 JOURNAL OF ECONOMICS QUARTERLY disutility of effort. No actual production or employment occurs at this date. but that the realization of s is known to neither. The model is a two-period one. as described above. This is an extreme assumption.e.) Thus. there is asymmetric information at date 1.6 We shall assume that s > R. particularly if workers have better information about the realization of R' than does the firm.7 We suppose that at date 0..e. i.. 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. We shall assume that the worker'sreservation wage is independent of his wealth W. 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. is assumed not to observe s. One can 6. At date 0. the firm's output is s. the marginal product of labor exceeds the reservation wage with positive probability. i. before any employment decisions have to be made. the firm learns the realization of s. the firm's output is zero. i. For models in which the reservation wage is allowed to depend on wealth. which could be relaxed. 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. in contrast. when the contract is signed. 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). 8. Matters become complicated (and more interesting) if R' is a random variable. see Chari [1983] and Green and Kahn [1983].e. however.

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

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

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

However. we have assumed that the contract specifies a certain wage w (s) and employment level L(s) for each s announced by the firm.e. that is.14 1 is a pair (w.4) V(s . Maskin [1981] has shown that it may be desirable to make the contract stochastic. (A1)-(A2) also ensure that as long as the constraint set is nonempty.2) is the firm's expected utility.V(. the worker receives a net income of (wu + k . 15 The left-hand side of (2. where 7ro2 Wu. -wuEY. In the situation given in the text. one can imagine that the firm earns profit 7ro elsewhere which is sufficient to cover its wage bill. since when s > k the worker is employed and paid (k + wu). An optimal contract under asymmetric information is a pair (wuk).R)EY. A contract when only the firm observes the state at date satisfying s < k < .e. Under (A1)-(A2). we have confined our attention to deterministic contracts. if not.G(k)) + U(wu)G(k) 2 U WUEf. it can be shown that stochastic contracts have no advantage over deterministic contracts.w (s). while when s < k the worker is unemployed and paid wu. DEFINITION. Such schemes make the firm's profit sL (s) . which maximizes Ss k (2. Recently. if at date 1 the firm announces that the state is s.. i.Wu. having signed such a contract. the realization of L (s) and a(s) are determined by an objective lottery over which the firm has no control.R)(1 . Thus. Expression (2. We assume that V is defined for some levels of negative income (if W. L (s) is the outcome of the lottery. once this announcement is made.. In particular. . the firm's actual profit will be a deterministic function of 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.k)g(s) ds + V(-wu)g(s) ds U(wu + k .2) subject to (2. the insurance company will guarantee the firm a certain income of E[sL(s) .132 QUARTERLY JOURNAL OF ECONOMICS DEFINITION. ? 0).3) will hold with equality.iV (s) a stochastic function of s. note that it may be difficult to implement a random contract. so there is some benefit from randomization that will disappear when L is a continuous choice variable and the production function is concave. there are k . if the worker cannot monitor (and hence prevent) such insurance. where w(s).3) and (2.3) gives the worker's expected utility.R) when employed and wu when unemployed. since. the firm can always increase profit by reducing wu. to specify a random wage iv (s) and employment level L (s) conditional on the announcement s. that is.C(s)] in exchange for the firm giving the insurance company sL (s) . (2. L is discrete. Note that there is no moral hazard in such an arrangement. s < k s. (wu + k . the firm will always wish to go to a (risk-neutral) insurance company and arrange that. Alternatively. where the realization of &(s) and L(s) is determined by an objective lottery. 15.wu sat14. In the above. since the insurance is conditional on the announcement s and.w) = W(7ro.w>) for some function W. when the set of feasible employment and output levels is convex.. Under such conditions. i.

the optimal contract is unique. an optimal contract exists. the optimal contract under symmetric information can be implemented even when there is asymmetric information. PROPOSITION 1.e. ex post efficiency is always achieved and so unemployment occurs if and only if s < R. Since the firm's expected utility 16. i.2)-(2. In general. V" (or) = 0 for all wrEY'. Let (WUk) be an optimal contract. 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 R < s. For when V' = constant.1) is w(s) = wu + R for s satisfying L(s) = 1. the solution of (2. and (b) R > s. k = max(s. there is full employment under symmetric information. 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. i. if the probability of unemployment is positive under symmetric information. there may or may not be unemployment under asymmetric information. when s is common knowledge. that is. depending on the exact form of U.16 Proposition 1(2) says that the probability of unemployment will still be G (R) under asymmetric information if the firm is risk-neutral. (3) if R > s and the firm is risk- averse. provides some information about the form of an optimal contract. We will consider this case further in Section V.. unless both the firm and the worker are risk-neutral. then k > R. V"(wr)< 0 for all 7 E Y'. there may be more than one optimal contract. the probability of unemployment is G(R)). However. V. and this yields efficient employment..e.R).3)-(2.G.e. -wd0'.4) is nonconvex. Note finally that Proposition 1(1) also tells us that. (In contrast. Proposition 1 says that the optimal k may exceed s or it may equal s.) The proposition below. When we speak of the Walrasian model. which was also proved in Grossman and Hart [1981]. U(w-) = U. this wage path can be realized under asymmetric information by setting k = R. unemployment will not occur in states close to Th Proof of Proposition 1.IMPLICIT CONTRACTS UNDER ASYMMETRIC INFORMATION 133 isfying (2. we are referring to the standard model in which there are no training costs or locking-in effects. (2) if the firm is risk-neutral.. and where there is simply a spot market for labor at date 1. Assume (A1)-(A3)..4). The nonemptiness of the constraint set is guaranteed by (A3).e.. Then (1) s-> k > R. i. If the firm is risk-neutral.e. i. in an optimal contract. i. This is because the maximization problem in (2. There exists i satisfying wd0. .

5) cannot hold when s < k < R < s-.k) dG + V'(-wu) dG U'(wu + k .Wu .On the other hand. although part (3) may not (i. However. Consider the first-order conditions for the problem (2.R)(1 . the left-hand side (LHS) of (2. Q.Wu. if k < R. since U'(wu + k .D. Hence part (1) is true.R < wu and so the worker prefers to be unemployed). wages cannot be conditioned on s directly. but only on observed variables determined by s. such as em- .Wu. if k = s-. Note that when G is discrete.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). Proposition 1 holds for the case where G has a density function g. If G is discrete. Hence (2. since V'(s .R). Note also that the first-order conditions are not satisfied at k = s-. we may have k = R). we must replace the equality by >.G(k)).e.5) < (1 . We prove part (1) for the case R > s.. with equality in (2.2)-( <. Note that part (1) clearly holds if R < s. 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 .5) = (1 .G(k)).E. If the worker cannot observe s. This proves that k > R.U(wu + k .4).R) > U'(wu) and U(wu) > U(wu + k . this proves part (2).k) < V'(-wu) when s > k. This establishes part (3). These yield V'(s -kWd (2. it matters whether s = k is an employment state or an unemployment state. the right-hand side (RHS) of (2.G(k)).3). If V" < 0.) Since V'(s .5) > (1 .R)(1 . For when k = R. while the left-hand side < (1 . Proposition 1 supports the intuition given in the introduction. since k > s.G(k)).G(k)) + (U(wu) . (If k = s.k) < V'(-wu) for s > k.5) -fk)dG V'(s .G(k)) + U'(wu)G(k) if s < k < s-. Remark 1. Since the firm is indifferent between employment and unemployment when s = k. the right-hand side of (2.5).R))g(k) U'(wu + k . the above argument shows that k = R also does not satisfy (2. it can be shown that parts (1) and (2) still hold. the first-order conditions are also not satisfied if s = k < R.

in terms of this paper. In particular. In the taxation problem. but because of moral hazard this is not possible). it may be necessary for employment to vary more than is desirable from an efficiency standpoint. Thus.e.> We = w. In our model the firm has information that the worker does not. 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). that the level of employment under asymmetric . but instead must base taxes on the observed consequences of ability. The government would like taxes to depend on ability directly. It is involuntary in the sense that the worker is better off in employment states than in unemployment states (for k > R .e. i.. the government is risk-neutral. 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. i. Remark 2. in order to get the right degree of risk sharing. One may ask whether the unemployment that occurs at date 1 is voluntary or involuntary. Finally. but instead must base wages on the consequences of this information. 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. 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.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])..e. As a result. in particular in states satisfying k > s > R. labor supply or income. employment levels. i. + k . 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.R > wj) and hence the worker regrets the fact that he is unemployed. 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 consumer-worker has information about his ability that the government does not. In contrast. our result that unemployment will not occur in states close to s.. whereas in the tax model one thinks of the government taxing a large number of different people in different states. For this reason.e.. the government in the tax model needs to balance demands and supplies only in average or expected terms. The firm would like to make wages depend on this information directly. i.

(R) = w. We know from the proof of Proposition 1 that. Also. Hence w. In order to answer this and other comparative statics questions. 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. (k))G (k) = U. is also a function of wu. Finally.) Thus.3) is increasing in w1.where U(MO) U (the existence of UT is guaranteed by (A3)). The firm's expected utility EV. and that obtains comparative statics results for some special cases.k. is differentiable for s > k > max(s. given by (2. 17. . (3. if R > s.17 III. Proposition 1 is generalized to the case of a firm that employs many workers in Grossman and Hart [19811.R) < k < s.thatis.G (k)) + U(w. for max (s. the left-hand side of (3. is as in Figure I. A paper that adopts a somewhat similar approach to that taken here.3) to write wu as a function of k: Wu=wu(k). In this section we consider how this excess unemployment depends on the degree of risk aversion of the worker and firm. (k) + k . The left-hand side of (2.R)(1 . It is therefore natural to ask whether the probability of unemployment increases as the firm becomes more risk-averse. but may be increasing or decreasing in k (an increase in k raises the wage when employed but reduces the probability of employment).and therefore wu(k) < 6-. w.1) U(w.136 QUARTERLYJOURNAL OF ECONOMICS information is equal to the Walrasian level in the best state of nature.1) exceeds U when wu = w-. We therefore use (2. = Clearly w. for s > k > R. The model presented here is also an example of the principal-agent problem.3) when there is equality. is analogous to the result that the marginal tax rate should be zero for the most able (see Sadka [1977]).R). (Note that EV is decreasing in wu and in k. 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. Proposition 1 tells us that the probability of unemployment will exceed the Walrasian level only if the firm is risk-averse.(k). (s) = U-. it is useful to investigate the constraint (2. is Weitzman [19801.2). we can draw indifference curves for the firm in Figure 1.

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

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

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

However. It tells us that.e. any optimal contract has the property that Ik . Proof. (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.4).k < E. if U and V are exponential. where a > 0. Q. If we substitute R' = R + a. Let the random variable &be replaced by (&+ a) and R by (R + a). Under symmetric information this will lead to a lower probability of employment.k) is an optimal contract initially. Consider first what happens if there is a uniform shift to the right in the distribution of s.4) remains the same. &is replaced by (9 + a) and R by (R + a). i. where a > 0.E. IV. Let R . we have 8. In particular. the probability of unemployment = prob(g < k) will not change. the maximum increase in the probability of unemployment relative to the Walrasian case. In particular. See Appendix.D. Proof. there exist a. (2) given E > 0. PROPOSITION Assume (A1)-(A3).140 QUARTERLY JOURNAL OF ECONOMICS optimal contract. and R increases by the same amount. where ab > 0. In the case of symmetric information the probability of unemployment = prob(9 < R) is unchanged by this. depending on how risk-averse the firm and worker are. Then. given G. w = wu. We now analyze the effect of changes in the distribution function G. Under asymmetric information. is G(k) - G(R).k + a) will be an optimal contract after the change. Proposition 6 is useful if we know the distribution function G but do not know the form of the utility functions U and V. Proposition 7 says that the same is true under asymmetric information. PROPOSITION Let the firm's utility function be given by V(ir) = -ebr and the worker's by U(w) = -e-aw.. &' = s + a. it appears difficult to say what will happen in general. k' = k + a in (2.4 > 0 such <? that if (-V"(7r)/V'(7r)) > a for all ir and (-U"(x)/U'(x)) for all x. which can be explained by the implicit contract-asymmetric information theory.2)-(2. We consider now what happens if there is an increase in R.2)-(2. k < k. the probability of unemployment can lie anywhere between G(R) and G(k). 7. problem (2. if (w>. but s stays the same.

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

It follows that if we substitute R' = XR. however.E. 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. Q.G(k)). the firm cannot pay the worker a positive wage when it does not employ him. It follows that when s can take on only two values. The reason for introducing ro is that constant relative risk aversion utility functions are defined only for nonnegative wealth. SL with probability WLand SH with probability 7rH. problem (2. It is then quite natural to scale iro by X too. V' = XaJ. Then under symmetric information we get em- . &' = As. but this will not matter for what follows. wi = Xwn. If SL ? R < SH. The same is true for U. where rL + 7rH = 1. V.4) remains the same. In general. In the next section.D. as we noted in Proposition 6 of Section III.2)-(2. if iro = 0. In particular. k' = Xk. the optimal k will be close to k. it appears difficult to establish further results about the behavior of k as a function of the distribution function G.142 QUARTERLY JOURNAL OF ECONOMICS function). where (5.R)(1 . This case violates our assumption that G has a density function. k 2 SL. Therefore. parts (1) and (2) of Proposition 1 continue to hold (see Remark 1 of Section II).e. An illuminating special case is where s can take on only two values. In this case. then Proposition 1(1) tells us that employment will occur if and only if s = sH.. i. and xH > 0. 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. 7rL > 0.1) h is the smallest value of k that maximizes (k . The best way to think of wo is as the output (revenue) of the firm coming from sources other than the worker's production. we see that there is no difference between symmetric and asymmetric information. the only interesting case is where R < SL < SH. 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. Since this employment rule is also optimal under symmetric information.

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. It is possible to have either wu(sH) > Wu(SL) = (W + R . Except for the discontinuity.e. Thus.(k))7rL =U ifsH>k>SL- As noted in Remark 1 of Section II.Thus.3) holds. is given as follows for SH > k ' SL = max(SL. Suppose that &takes on just two values-SL . If the firm is infinitely risk-averse. respectively. there exist a.SL) or Wu(SH) < Wu(SL). if (5. <? for all w. s = k is always considered an employment state when k > R. Note that there is a discontinuity in w. w>(k) is decreasing in k. it is obviously optimal to maximize k.R) and (.2)). 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. that is.3) holds. G(s) = 0 for 0 < s < SL. the two cases yield profit for the firm in the worst state of (SL . G(s) = 7rLfor SL < s < SH. In the second case the worker's wage when unemployed = Wu= H(k -R). to set k = SH. V. (k) at the point k = 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.R)).3) SL -R < rH(SH R).R. where R < SL < SH.V satisfy (A1)-(A3) and (-V"(7r)/V'(7r)) > a for all ir. (limk+SLWU (k) > wI (SL)).-J. G(s) = 1 for s > SH.SH. In the first case k = SL and the worker's wage when employed is w + R (see (5.)Furthermore.G(k)) is replaced by prob[9 > k]).2) U(wu(k) +k-R) U(wu(k)+k-R)7rH+U(w. It is easy to show that Proposition 6 continues to hold in the discrete case (where (1 . 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. then every optimal contract (-U"(w)/U'(w)) . If R < SL < SH. the firm's profits in the worst state are SL . The optimal contract involves either employment in both states or unemployment when s = SL.a7 + 7rH(SH . as defined in (3.1). i.aT.IMPLICIT CONTRACTS UNDER ASYMMETRIC INFORMATION 143 ployment in both states. in the discrete case./ > 0 such that if U. wU(k). (k > SLmeans that unemployment occurs in the bad state s = SL.. We therefore have as a special case of Proposition 6: PROPOSITION10.R): = UU(i) if k =SL (5.

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. (k .3) tells us that unemployment is more likely to occur in the bad state (A) the lower is the probability of the bad state. Condition (5.1).R) is small. and this is very important to a highly risk-averse firm even if the probability of s = SL is low. as shown in Figure II. we have a relationship between the probability of unemployment and 7rL.SL)/(SHextremely risk-averse firm and an approximately risk-neutral worker.G(k))+ (see Proposition 6) is maximized at both k = SL and k = SH-18 That (k .R)). the probability of the bad state. The probability of unemployment will then be rjL.R)). the gain from improved risk sharing may be large. For if (5. the expected efficiency loss that results from making s = SL an unemployment state is small.3) holds. if SH. while a proportionate change in s and R will lead to the same proportionate change in k. if k satisfies (5. In contrast. Clearly.R). an increase in rTL reduces the probability of unemployment. then an increase in R can be shown to reduce k. Similarly. Thus.R) constant and vary rjL. 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. In particular. if (5. (B) the lower is the net social return in the bad state relative to that in the good state.3) is unaffected.Then we know from Proposition 10 that. the relationship is not monotonic. The probability of unemployment reaches its supremum as rL . if (5.G(k))+ has two maxi18.R)(1 .3) holds and the firm is sufficiently risk-averse and the worker is approximately risk-neutral. . If 7rL or (SL . Suppose that we keep (SH . 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. then (5. V. (1 .SL)/(SH SL)/(SH .144 QUARTERLY JOURNAL OF ECONOMICS satisfies k > SL. In fact. if the firm is extremely riskaverse. This is because by making s = SL an unemployment state the firm is able to reduce wages in this state.R)(1 . In particular. then it will continue to hold if R increases. unemployment will occur for some U. unemployment will occur when s = SL. SL and R are all increased by the same proportion. ConR). (A) and (B) are fairly intuitive.G(k))+ denotes the probability that s > k.3) holds initially. Note that in the limit when 7lL = ((SH ((SH . (SL . That is.3) will hold for all irL < (SH . given an dition (5. after a certain point. Proposition 10 also enables us to determine for what two-point distribution the probability of unemployment will be highest.

7r?) = (S3-R)(1 . If we return to the case where s takes on two values.r > G(k))+ .. . respectively. .si)/(sn . rn as variable.irn ) EAn . .. sn as well as 7r1.. where k is given by (5.R) lsi>k - 0}. the limiting distribution in which G (k). with each si > as R.EA (sn - si)/(sn R). 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. the probability of unemployment tends to one in the former case. . . Note that by regarding s1. This shows that.R). if we regard the wri's variables. ."achieves" the supremum has the property that (k .R) as close to one as we like (simply let si R).be the probability that s < x.. For as s1 R. letk(7r) maxiri. then.R)(1 - = {7rERn 1l ri = 1. Thus.G(k))+ is constant for k equal to the mass points of s. In other words.R) and in the limit 7r?.R) = (s2 . < * < sn. Proof. while it equals zero in the latter 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.. . < sn. . the probability of unemployment. PROPOSITION 11. Urn.R)(1 . has a supremum equal to (Sn . ir satisfy (5.. ... The next proposition shows the following: if s can take on n values s.G (k)-. the maximum probability of unemployment when both ir and the risk aversion of the worker and firm are variable is (Sn .4) (s. .sV)/(sn .. if the distribution function G can be chosen arbitrarily.. . Suppose that s can take on n fixed values s1 < S2 <.R)(1 . . we can make (Sn . For each vector of probabilities 7r = imize (h G(k(r))-= (Tro. See Appendix.... under the conditions of Proposition 11. Let G (x).7r-ir0) (sn -R)nr.. Then sup. we can also ..1). where each si > R.(k .Si)/(Sn . with probabilities 1.

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

VI.G). If the firm's owners are riskaverse. 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. the above cannot happen if the signal p gives perfect information about s. This is true for a number of well-known distributions such as the normal (see Barlow and Proschan [1975]). employment is a good instrument for inducing incentive-compatible risk sharing.R)(1 . among other things. Then k maximizes (k . The right-hand side of (5.IMPLICIT CONTRACTS UNDER ASYMMETRIC INFORMATION 147 Of course. In a world where &is common knowledge. Clearly how a change in the distribution function G affects the probability of unemployment will depend. The . 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. Equation (5. increases in riskiness and improvements in informativeness do not generally affect the hazard rate in a simple way. 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.5) k-R = (1 - G(k))/G'(k). on how it affects the hazard rate G'/(1 . When &is not observed by workers. Thus. 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). 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).5) will have a unique solution if the hazard rate is increasing. (5.G(k)). which yields the firstorder conditions. Unfortunately. the wage bill cannot be made an arbitrary function of the true ?.5) is the reciprocal of the hazard rate of the distribution G. since workers cannot determine ?. optimal risk sharing requires a fall in the firm's wage bill when &is low. this need have no implication regarding employment (especially if labor supply is inelastic). 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.

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). the more risk-averse is the firm and the less risk-averse is the worker. but not the employment level in the firm as a whole. Even if the firm uses an insurance company to achieve risk sharing. Note that once s is unobservable. The cost of unemployment is that it is ex post inefficient. variations in productivity s (in the region where s > R) will lead to variations in employment under asymmetric information.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.. the insurance company unable to observe s would find it in its interest to condition income transfers on the level of employment. employment is a useful screening device for any party that the firm wishes to share risk with. gross profit s is not common knowledge. Since the benefits in terms of risk-sharing are unaffected by the magnitude of (s . in particular.e. and thus unemployment will be higher. i. we showed that if L can take on any finite number of values.R). In this paper we have concentrated on the case where L = 0 or L = 1. If s could be observed by the market. benefits from risk sharing will be higher. As we showed in Section III. however. .where ax> 0. Note that all our results generalize to the many-worker case if each worker can observe only whether or not he is employed. 19. 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. 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. 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). then the owners of the firm could condition income transfers directly on the realization of g. This was made precise in the Corollary to Proposition 8 in Section IV. reduces the probability of unemployment. this suggests that the optimal amount of unemployment will be lower the smaller is the probability mass of states close to R. By "unemployment will be higher. they are risk-averse. if workers can observe the employment level in the firm. and (2) that the only variable which is common knowledge is employment. wages can be conditioned on this variable. As a result." we mean that even though labor supply is inelastic under symmetric information (over the region where wages are larger than the reservation wage R). which showed that a shift in each s from s to s + ax. The difficulty in generalizing the comparative statics results of this paper to the case of many workers stems from the fact that. In Grossman and Hart [1981].

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

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. It is at the very essence of the model that labor supply response is asymmetric. and Maskin [1982] develop a general equilibrium model of implicit contracts in order to explore the above asymmetric effect. In a model of relative demand shocks across industries.E [x IInfo]. . A model where the relative demand shocks are caused by wealth re20. 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] . As a consequence of this. Though Lucas [1972] and Barro [1976] consider models where "inefficient" unemployment occurs because of monetary nonneutrality. In linearized versions of Lucas' [1972] model such as Barro [1976]. In all of these Lucas-like models. Grossman. 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. the above asymmetry implies that relative demand shocks decrease employment by more than they would under complete information. Workers in a particular submarket have incomplete information about the real interest rate. In particular. while bad states lead to non. Good states lead to Walrasian levels of unemployment. For example. Further.Walrasian levels of unemployment. there are versions of Lucas' model where the driving shocks are real (not nominal) and the inefficiency in output also depends on expectational errors. and this leads to labor supply fluctuations.P). we were able to show that the level of employment under asymmetric information equals the Walrasian level in the best state of nature. In our model this is not the case. 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.E[r Iinfo]). the driving variable that converts long-run inelastic labor supply into a short-run elastic labor supply is a variable like x . Hart. 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).20 In all of these models this is a symmetric variable.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. 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 .

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

a firm with utility function V prefers k = k (a) to k*. Note that as a a ).5) > 0. Proof of Proposition 3: Step 2. and I2 be two functions of s that are bounded above by a number b.W'k'. It follows from Lemma 1 that a firm with utility function -e-a will prefer k = k (a) to k = k*.2)-(2. It follows that the distribution of max(s . suppose that it is false. To establish the last part of the proposition. for a large. then he will always choose the gamble with the higher minimum value. we may conclude that wu(k*) < w (k (a)) < wu (k (a)) + k (a) < wu (k*) + k*. Using the argument of the proof of Proposition 2. kI') to (i . Proof of Proposition 3: Step 1.152 QUARTERLY JOURNAL OF ECONOMICS large s under (dIP) u(s) max(s - than under (&. But this contradicts Lemma 2.- k.e. U A Proof. Q. for a sufficiently large. the first two terms are bounded. a firm with utility function -e-at prefers the profit stream with the higher value in the worst state. one shows that k' = k violates the first-order conditions (2. -wu) is negative for s < some s* and positive for s > s*. Then. since otherwise k (a) would not be preferred to k*. if a is sufficiently large.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. EV(11) < EV(I2). We have shown in Section II that k < k*. the firm's profit stream when k = k (a) will satisfy the single crossing property relative to the profit stream when k = k*. This proves that k' > k. Now dwu/dk = -RHS of (2. By definition. -K u) satisfies the single crossing property with respect to the distribution of max(s By Lemma 1. while the third term goes to positive infinity. again by the proof of Proposition 2.Ik) and a less risk-averse firm (weakly) prefers (i. To prove (2). Wu (a)) (k wu (k) > wu(k*). {EV(12) . the left-hand side of the expression is positive. As a goes to infinity. w- k'. Let Ii infix Iprob(Ii < x) LEMMA2. Suppose that I < 12. Suppose that V(x) = -e > 0 for i 1.D./k) to (KIk).4).E. Then we can find a sequence of optimal k (a) converging to k < k* as a a) .E.D. - . Hence k < k*. -w4) - max(s - .D. this contradicts the fact that a more risk-averse firm (weakly) prefers (A.. Let I. Q. . Q.I).2. We show that if a person has constant absolute risk aversion of a sufficiently large size. which says that. But LHS of (2. Hence.E.5) = 0 at k = k*. Therefore.5). and so k = k* does not satisfy the first-order conditions for problem (2. i. We shall need the following lemma.

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).2) yields an objective function for the firm of the form U(-b/a)4. When a is large. then wu = W. It is easy to see that WU is decreasing in k and (wU+ k) is increasing in k. for the case where U is linear.R).. the firm pays in the limit hi when the worker is unemployed and more than (h + R) when the worker is employed. then wu = w-satisfies (2. In the exponential case. this can be written as e-alwuq(k) = U.1) f V(s-kw-u) dGJ+ V(-wU) dG = V. (A. it is enough to establish that k* < k when U is nonlinear. Hence fix V and let the worker become more risk-averse.s + R satisfies (2.5). If k = R. Substituting in (2.(k) < tu (k)+ k < Cvuk') + A'. Then the worker's net income is w (k) < w if unemployed and wu(k) + k .with certainty (see o a. Therefore. Take k > max(s. where k* is defined in Proposition 3.R with probability (1 . One proceeds as in the proof of Proposition 3. In both cases the worker'snet income is ff with probability 1. increase a. In view of Proposition 3.R). Clearly the firm could do better by setting k = max(s. It follows that A' ? k. If k = s > R. i. defined in (3. Assume that k' > A. (k). where 0 is a function of k. That A'< k if s < R follows from the fact that A'= k is not consistent with the first-order conditions (2..E.max(s. It follows that the optimal k is independent of U in the exponential case. wu(k) must be close to w-for the worker to (k) be indifferent between the lottery (wu(k) with probability G (k). the workeris risk-neutral.(k). to express wUas a function of k: wU = vu(k).D.e. i.D. But this means that Lemma 2). The above argument shows that in the exponential case the optimal k will be independent of V. Consider (2. This proves that k(a) .1).R when employed) is riskier in the sense of the single crossing property when k = k' than when k = k. Note first that k is by construction the smallest value of k that minimizes wu(k). The proof breaks down because V changes when the worker becomes more risk-averse and the optimal k is not independent of V.G(k))) and w.a) -*wh as a if k is bounded away from max(s..Use the equation. Suppose that k* > k.e. Hence k' > Aimplies that a. i. Proof of Proposition 5.e.IMPLICIT CONTRACTSUNDER ASYMMETRICINFORMATION153 Proof of Proposition 4.3) for all utility functions U.R) as a -a co. wu + k . WU + k . Then wU(k*) < w..3) for all utility functions U. Proposition 4 does not appear to hold for general utility functions. In particular. the worker's net income (wu when unemployed.E. to prove part (1). the worker is very risk-averse.3).(k ') < w.R). wu (k. where wu refers to the nonlinear utility . by Lemma 1. Proof of Proposition 6. This contradicts the fact that the worker prefers k to k' when a = ao and A'to k when a = a.R if employed. Q. Q.

(k*) + k* .which solves (5.R with probability (1 .154 QUARTERLY JOURNAL OF ECONOMICS function U. Differentiate (A. w (k) + k . But this means that a risk-averse worker with utility function U is indifferent between the lottery L1 = (w.R. k < sn-1. it follows that EU(R + a.R)(1 = G(k)) is greater at k = s1 than at k = Sn.4).3) (R.D.R).R). 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. The latter constraint may be used to solve for wu = Jv (k).Si)/(Sn .Si)/(Sn . for the probability of unemployment to exceed (Sn . I' = fIviolates the first-order conditions (2. To prove (2). Proposition 3(2J tells us that there exists a such that (-V"(w )/V'(ir)) > a ==k . Suppose that k' < k. Therefore.R). wu(k*)G(k*) + (wu(k*) + k*. Thus.G (k*)) > (k .R)(1 .R). But then (k .R)(1 . But this means that L1 is riskier in the sense of Diamond-Stiglitz [1974] than L2.. But this contradicts the fact that I' is optimal under This proves that I' ' I.k') (I is initially optimal). This contradicts the definition of k. we must have -rn < (s .k) = U('u(k))G(k) + U(wu(k) + k - R)(1 - G(k)).E.R). This yields (A. we can ensure that (k . and so a risk-neutral worker will prefer L1 to L2. since (k . it follows that OEU/IR is larger the larger is k (since (ith Ck) + k) is increasing in k). weLk*) + k* -R with probability I .G(k)) cannot reach a maximum except at a mass point. To show that the probability of unemployment cannot exceed (Sn . where Cvu is decreasing in k and (vu (k) + k) is increasing (k) in k. .7r?) = (Sn . As in the proof of Proposition 4.2) EU(R.k) > EU(R + ak') given that k > k'. since wu(k*) < wu(k). Q. Hence k < Sn. This shows that employment will (R+ a).R > wu(k) + k . it follows that w. Proof of Proposition 11. Thus. suppose that it does. Since the probability of employment is lower under L1. Hence we may write the worker's expected utility as (A.e. Proof of Proposition 8.R)(1 .k) __5_R_ = -U'(vu (k) + k - R)(1 -G (k)). Finally. the probability of unemployment can be made arbitrarily close to (1 .5). From this.k I < e. Since we know that EU(R.G(k))+ is maximized at k = Sn.G (k))). i.2) with respect to R.ik) ' EU(R.G(k*))) and the lottery L2 = (wa (k) with probability G(k). That the same is true if the worker is approximately riskneutral follows from a continuity argument. note that if the worker is risk-neutral.R)/(sn . By choosing 7rclose to the 7r.R)(1 -G(k*)) > wu(k)G(k) + (wu(k) + k - R)(1 -G(k)) which implies that (k* .( . Note that by Proposition 1(1) we always have employment when s = Sn.G (k)).S)/(Sn . (k*) with probability G(k*).

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