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].

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

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

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

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

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

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

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

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

2)-(2. In general.. -wd0'. the optimal contract under symmetric information can be implemented even when there is asymmetric information. which was also proved in Grossman and Hart [1981].. (3) if R > s and the firm is risk- averse. in an optimal contract. unemployment will not occur in states close to Th Proof of Proposition 1. i. Assume (A1)-(A3).IMPLICIT CONTRACTS UNDER ASYMMETRIC INFORMATION 133 isfying (2. and where there is simply a spot market for labor at date 1. the optimal contract is unique. U(w-) = U. i.e. unless both the firm and the worker are risk-neutral. this wage path can be realized under asymmetric information by setting k = R. there may or may not be unemployment under asymmetric information. If the firm is risk-neutral. V. the probability of unemployment is G(R)). If R < s.R). Then (1) s-> k > R. if the probability of unemployment is positive under symmetric information. 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.. There exists i satisfying wd0. depending on the exact form of U. Since the firm's expected utility 16.e. This is because the maximization problem in (2.16 Proposition 1(2) says that the probability of unemployment will still be G (R) under asymmetric information if the firm is risk-neutral. i. there may be more than one optimal contract. there is full employment under symmetric information.e. Proposition 1 says that the optimal k may exceed s or it may equal s.4) is nonconvex.e. When we speak of the Walrasian model.e.4). that is. then k > R.1) is w(s) = wu + R for s satisfying L(s) = 1. and (b) R > s. PROPOSITION 1. For when V' = constant. an optimal contract exists.G. V" (or) = 0 for all wrEY'. k = max(s. However. i. V"(wr)< 0 for all 7 E Y'. The nonemptiness of the constraint set is guaranteed by (A3). and this yields efficient employment. 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. (In contrast. we are referring to the standard model in which there are no training costs or locking-in effects. Let (WUk) be an optimal contract. i. the solution of (2. provides some information about the form of an optimal contract..3)-(2..) The proposition below. Note finally that Proposition 1(1) also tells us that. . (2) if the firm is risk-neutral. ex post efficiency is always achieved and so unemployment occurs if and only if s < R. when s is common knowledge. We will consider this case further in Section V.

we must replace the equality by >.Wu. If the worker cannot observe s.E.Wu .G(k)).G(k)) + (U(wu) .5) = (1 .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).R)(1 .k) < V'(-wu) for s > k. Q. this proves part (2). but only on observed variables determined by s.On the other hand. we may have k = R). If G is discrete. Proposition 1 holds for the case where G has a density function g. while the left-hand side < (1 . it matters whether s = k is an employment state or an unemployment state.5) cannot hold when s < k < R < s-. the first-order conditions are also not satisfied if s = k < R.by <. if k < R.R))g(k) U'(wu + k .5). the right-hand side (RHS) of (2. it can be shown that parts (1) and (2) still hold.G(k)). This establishes part (3).e. Remark 1. such as em- . Consider the first-order conditions for the problem (2.5) -fk)dG V'(s . the left-hand side (LHS) of (2. This proves that k > R.. since k > s. (If k = s. the right-hand side of (2. since V'(s .G(k)). For when k = R. Note that part (1) clearly holds if R < s. Hence part (1) is true. Note also that the first-order conditions are not satisfied at k = 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 .k) < V'(-wu) when s > k. Note that when G is discrete.D. We prove part (1) for the case R > s. These yield V'(s -kWd (2.3).R).R < wu and so the worker prefers to be unemployed).5) > (1 .R)(1 . Hence (2. although part (3) may not (i. wages cannot be conditioned on s directly.G(k)). with equality in (2.4).) Since V'(s . However.R) > U'(wu) and U(wu) > U(wu + k . if k = s-.U(wu + k .Wu. Proposition 1 supports the intuition given in the introduction. If V" < 0.5) < (1 . since U'(wu + k .2)-(2. Since the firm is indifferent between employment and unemployment when s = k.G(k)) + U'(wu)G(k) if s < k < s-. the above argument shows that k = R also does not satisfy (2.k) dG + V'(-wu) dG U'(wu + k .

One may ask whether the unemployment that occurs at date 1 is voluntary or involuntary. labor supply or income. i. The firm would like to make wages depend on this information directly. but instead must base wages on the consequences of this information. in order to get the right degree of risk sharing. in the contract model one is interested in the case where the worker may be risk-averse. the government is risk-neutral. There is a close formal relationship between the model presented here and optimal income tax theory (see Mirrlees [1971]). i. the consumer-worker has information about his ability that the government does not. our result that unemployment will not occur in states close to s.. 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). i. In particular.e.e.. whereas in the tax model one thinks of the government taxing a large number of different people in different states. it may be necessary for employment to vary more than is desirable from an efficiency standpoint.e. i. It is involuntary in the sense that the worker is better off in employment states than in unemployment states (for k > R . 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. For this reason. but because of moral hazard this is not possible). It is voluntary in the sense that the worker is a willing party to the contract at date 0. In contrast.R > wj) and hence the worker regrets the fact that he is unemployed. The government would like taxes to depend on ability directly. in particular in states satisfying k > s > R. 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.. + k . Remark 2. As a result.IMPLICIT CONTRACTS UNDER ASYMMETRIC INFORMATION 135 ployment. Finally. the government in the tax model needs to balance demands and supplies only in average or expected terms. in terms of this paper. Thus.> We = w. In our model the firm has information that the worker does not. 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. employment levels. but instead must base taxes on the observed consequences of ability. that the level of employment under asymmetric .e. 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.. In the taxation problem.

136 QUARTERLYJOURNAL OF ECONOMICS information is equal to the Walrasian level in the best state of nature. and that obtains comparative statics results for some special cases. . A paper that adopts a somewhat similar approach to that taken here.R). = Clearly w.R) < k < s.) Thus. is analogous to the result that the marginal tax rate should be zero for the most able (see Sadka [1977]).G (k)) + U(w.2). (3. 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. The model presented here is also an example of the principal-agent problem.3) to write wu as a function of k: Wu=wu(k). but may be increasing or decreasing in k (an increase in k raises the wage when employed but reduces the probability of employment). for max (s. w. Proposition 1 is generalized to the case of a firm that employs many workers in Grossman and Hart [19811. it is useful to investigate the constraint (2. 17. 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. the left-hand side of (3. Finally. is also a function of wu.R)(1 . In this section we consider how this excess unemployment depends on the degree of risk aversion of the worker and firm.(k). (k))G (k) = U.17 III. Proposition 1 tells us that the probability of unemployment will exceed the Walrasian level only if the firm is risk-averse. for s > k > R. if R > s.thatis. is as in Figure I. We know from the proof of Proposition 1 that. The firm's expected utility EV. In order to answer this and other comparative statics questions. is differentiable for s > k > max(s.1) U(w. The left-hand side of (2. is Weitzman [19801. given by (2.1) exceeds U when wu = w-. Also.k.3) when there is equality.3) is increasing in w1. (Note that EV is decreasing in wu and in k. We therefore use (2. (k) + k . (R) = w. It is therefore natural to ask whether the probability of unemployment increases as the firm becomes more risk-averse. we can draw indifference curves for the firm in Figure 1. (s) = U-.where U(MO) U (the existence of UT is guaranteed by (A3)).and therefore wu(k) < 6-. Hence w.

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

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

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

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

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

however. Then under symmetric information we get em- . 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. The same is true for U.G(k)). &' = As. problem (2. In particular. where rL + 7rH = 1.4) remains the same. parts (1) and (2) of Proposition 1 continue to hold (see Remark 1 of Section II). It follows that if we substitute R' = XR. Since this employment rule is also optimal under symmetric information. SL with probability WLand SH with probability 7rH.1) h is the smallest value of k that maximizes (k . It follows that when s can take on only two values. then Proposition 1(1) tells us that employment will occur if and only if s = sH. V.2)-(2. 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. This case violates our assumption that G has a density function. 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. k 2 SL. if iro = 0. and xH > 0.D. i. the only interesting case is where R < SL < SH.E. it appears difficult to establish further results about the behavior of k as a function of the distribution function G. the optimal k will be close to k. wi = Xwn.142 QUARTERLY JOURNAL OF ECONOMICS function). V' = XaJ. 7rL > 0. as we noted in Proposition 6 of Section III. If SL ? R < SH. The reason for introducing ro is that constant relative risk aversion utility functions are defined only for nonnegative wealth. Q. The best way to think of wo is as the output (revenue) of the firm coming from sources other than the worker's production. the firm cannot pay the worker a positive wage when it does not employ him. but this will not matter for what follows. Therefore. we see that there is no difference between symmetric and asymmetric information. In the next section.e. k' = Xk. An illuminating special case is where s can take on only two values. In this case.. where (5. In general.R)(1 . It is then quite natural to scale iro by X too.

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

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

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

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

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

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

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

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

X)U for all U. Eg(U(Xl)) > Eg(U(X2)). Note first that it is im+ + kI./') to (Wuk). . Hence wu > dU. Q. wd <iWU <iWU+ k' <Wu+ k. i. But this means that whatever V is the firm will prefer (Wu.) on the whole real line.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.e. and assume that F2(x) # Fi(x) for some x. X2(s) be real-valued functions of s. Then Eg(U(X1)) > Eg(U(92))Proof. Suppose that Xl(s) and X2(s) are fuietions of s. For convenience. 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) .wu) is lower for small s and higher for W- . defined bygx (U) = Xg(U) + (1 . Suppose that Eg(U(X1)) < Eg( U(X2)). APPENDIX Proof of Proposition 2: Step 1. Therefore. Suppose that k' < k. X2 is riskier than X1 in the sense of Diamond-Stiglitz [1974]. that is. But this means that the firm's net profit max(s . define F1(. We shall sometimes say that X1 is less risky than X2 in the above case. the individual with utility function g-X(U) is indifferent between X1 and X2. (W/k) is never chosen.which means since then wU. strictly concave function. the individual with utility function gl(U) must prefer X1 to X2. The distribution function of s induces distribution functions on X1 and X2.k. since an individual with utility function g1(U) is more risk-averse than an individual with utility function g-x (U). Contradiction. Consider a person more risk-averse than person U in the sense that the new person's utility function is g(U(x)). and that a risk-averse person with U'(x) > 0 weakly prefers X1 to X2. Since Eg1(U(X)) < Eg1(U(X2)) and Ego(L(X1)) > Ego(U(X2)). Consider the class of concave transforms gx (-).D. That is. Proof of Proposition 2: Step 2. by continuity there exists X such that Egx-x(U(XD)) = Eg-x(U(X2)). 0 < X < 1.) the firm pays less both when the worker is employed and when he is unemployed.wu . A similar argumentshows that Wu+ k' < wu + k. where g(-) is a strictly increasing. LEMMA 1.F2(x) > 0 for x > x0. Let F2 satisfy the single crossing property with respect to F1.i. and hence there are more employment states under k'. It follows that. kI'< possible to have U < w'U. EU(X1) > EU(X2). Our proof will involve the use of the following lemma. say F1(-) and F2(-). in view of the single crossing property.E..e. Let Xi(s).. However. respectively. that under (wuik.

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

E. Proof of Proposition 6. In view of Proposition 3.. When a is large. to express wUas a function of k: wU = vu(k).. i. then wu = w-satisfies (2.R when employed) is riskier in the sense of the single crossing property when k = k' than when k = k.R).D. Proposition 4 does not appear to hold for general utility functions. One proceeds as in the proof of Proposition 3. In both cases the worker'snet income is ff with probability 1. Then wU(k*) < w. This proves that k(a) ..Use the equation.. Suppose that k* > k. WU + k . Hence fix V and let the worker become more risk-averse. i.R if employed.(k) < tu (k)+ k < Cvuk') + A'. for the case where U is linear.R).1) f V(s-kw-u) dGJ+ V(-wU) dG = V. Hence k' > Aimplies that a. by Lemma 1.with certainty (see o a. In particular.E. it is enough to establish that k* < k when U is nonlinear. 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).a) -*wh as a if k is bounded away from max(s. increase a.R). wu(k) must be close to w-for the worker to (k) be indifferent between the lottery (wu(k) with probability G (k). Therefore. the worker is very risk-averse.1). In the exponential case.3) for all utility functions U.3) for all utility functions U. The above argument shows that in the exponential case the optimal k will be independent of V. Assume that k' > A.(k). defined in (3.R) as a -a co. Consider (2.(k ') < w.IMPLICIT CONTRACTSUNDER ASYMMETRICINFORMATION153 Proof of Proposition 4. this can be written as e-alwuq(k) = U. where wu refers to the nonlinear utility . If k = R. (k). then wu = W. It is easy to see that WU is decreasing in k and (wU+ k) is increasing in k. Then the worker's net income is w (k) < w if unemployed and wu(k) + k .e. But this means that Lemma 2). Substituting in (2. to prove part (1). That A'< k if s < R follows from the fact that A'= k is not consistent with the first-order conditions (2. wu + k . the firm pays in the limit hi when the worker is unemployed and more than (h + R) when the worker is employed. Q. Take k > max(s. Clearly the firm could do better by setting k = max(s.max(s.e. It follows that A' ? k.5). This contradicts the fact that the worker prefers k to k' when a = ao and A'to k when a = a. where k* is defined in Proposition 3.2) yields an objective function for the firm of the form U(-b/a)4. Q.s + R satisfies (2.G(k))) and w.3).R with probability (1 . the worker's net income (wu when unemployed. the workeris risk-neutral. (A. The proof breaks down because V changes when the worker becomes more risk-averse and the optimal k is not independent of V. Proof of Proposition 5. i. It follows that the optimal k is independent of U in the exponential case.D. where 0 is a function of k.e. wu (k. If k = s > R. Note first that k is by construction the smallest value of k that minimizes wu(k).

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

But this means that (k . 3-36. L (Jan. and C. and Unemployment. Barro. Grossman.INFORMATION 155 IMPLICIT CONTRACTS UNDER ASYMMETRIC occur when s = sn-1 as well as when s = s. and Winston. "Recent Developments in the Theory of Inflation and Unemployment. "Expectations and the Neutrality of Money." Brookings Papers of Economic Activity (1980).. VIII (1974). 1983)." mimeo. Lucas. Moral Hazard. "Wage Employment Contracts. 185-219. G. . Inc.. and F. and E. Hart. < (si .. 1979). P. and so k < Sn-2. G. and H. XCVIII (1983). 173-87. "Employment with Asymmetric Information. "Heterogeneous Information and the Theory of the Business Cycle.. XCVIII (1983). Maskin." American Economic Review. Rinehart.13-34. and E. 1975). "Optimal Labour Contracts Under Asymmetric Information: An Introduction.." Review of Economic Studies. Stiglitz.. O. University of Pennsylvania. III (1976).. the probability of unemployment is zero. Journal of Political Economy. R. 1-32. J.R) < (s . .D. Supplement. R..R). Q. .. Grossman. P. 1979). Azariadis. Supplement. Hart.. "Increases in Risk and Risk Aversion. UNIVERSITY OF CHICAGO LONDON SCHOOL OF ECONOMICS REFERENCES Akerlof." mimeo." this Journal. R. S.E. Continuing this argument yields k = sl.. 1982. R. i. Supplement. Calvo. 337-60.R). Green.. Statistical Theory of Reliability and Life Testing (New York: Holt. Gordon.and D. Dasgupta. Kahn. "Employment Contingent Wage Contracts. LXXI (1981). XLVI (April. 0. II (1976).." this Journal. P. 1159-60. Diamond.. 321-38. "Randomization in the Principal-Agent Problem.sl)/(s. LXIX (Dec. Hall. 1979. "Unemployment with Observable Aggregate Shocks." Journal of Monetary Economics. "Implicit Contracts and Related Topics: A Survey. and J. 157-72. Weiss. R. 160-68. Hammond. "The Implicit Contract Theory of Unemployment Meets the Wage Bill Argument. S. Thus. V (1977). XLVII (Jan.e. "The Implementation of Social Choice Rules: Some General Results on Incentive Compatibility. we must have Wn-l + r.R)/(s . Maskin. "Implicit Contracts." Journal of Economic Theory. and E. 185-216." this Journal. But this means that employment occurs in all states. Proschan." Review of Economic Studies.. 107-22. . and 0. IV (1972). which is a contradiction. XC (1982). V." American Economic Review." Journal of Monetary Economics." Journal of Monetary Economics. 1980). 868-79. "Employment Fluctuations and Wage Rigidity.R)/(sn. "An Annotation of 'Implicit Contracts and Underemployment. Barlow. XCVIII (1983). Bryant.R)(1 .. 1981. 301-07. "Efficient Wage Bargains Under Uncertain Supply and Demand. E.. J. Supplement." Journal of Economic Theory. Lilien. for the probability of unemployment to exceed (s..' "Journal of Political Economy." Working Paper #79-17. S. "Rational Expectations and the Role of Monetary Policy. 696-727. C. Hart. "Involuntary Unemployment and Implicit Contracts...G(k)) is greater at k = s1 than at k = Sn1.. Maskin." Review of Economic Studies. 91-124. LXXXVI (1978). Grossman. Phelps. Hence k < Sn-1. Chari. and L. --. Miyazaki..

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