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

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

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

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

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

then their expected utilities at date 0 can be increased). s is observed only by the firm. In fact. We suppose. at date 1.g. There is an obvious and unimportant ambiguity when s = R. Matters can be simplified considerably by appealing to results from the incentive-compatibility literature. We analyze the optimal contract in terms of the following revelation game.. See Azariadis [1979].w(s)) (21) *~ ~~~V U (W. The contract then specifies a wage w(s) and an employment level L(s^)(equal to zero or one). For if production does not occur in some state s > R. whether L(s) = 0 or 1. Under (A1)-(A2). e. Finally.. at date 1.R + E.e. it can be shown that without layoff-redundancy pay the ex ante optimal employment rule is employ if and only if s > k. a constant. where k is a number less than R.) V(-Wu) over states s. which satisfy L(s) = 0. 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. it is no longer the case that ex ante optimality implies ex post efficiency. then both parties can be made better off by letting production occur and increasing the wage from w(s) to w(s) + R + E. however. . Equation (2.R) V'(s . If layoff-redundancy pay is ruled out. The reason w(s) is constant over unemployment states is that social output is constant (equal to zero) over such states.It follows that any ex ante optimal contract must specify the employment rule: employ if and only if s > R. We turn now to the more interesting case where. where E > 0 is small. this involves choosing the wage function w (s) such that w (s) = we. if production occurs when s < R. and U'(w(s) .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. we will be chosen so that the worker's expected utility equals U. conversely. over the states s. the firm is asked to announce the realization of g it has observed. that the worker does observe whether he is employed at date 1. 11. This will be chosen to ensure optimal risk sharing between the firm and the worker. We suppose that. where L(s) = 1.11 The remaining part of the optimal contract when s is common knowledge at date 1 concerns the wage function w(s). Now a necessary condition for ex post Pareto optimality is that production should occur if and only if s > R. This argument depends on the possibility of layoff-redundancy pay. both parties can be made better off by stopping production and reducing the wage from w (s) to w (s) . conditional on the announcement s = s'. i.130 QUARTERLY JOURNAL OF ECONOMICS state s and no worse off in any other state.

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

the worker receives a net income of (wu + k .wu sat14. 15 The left-hand side of (2. we have assumed that the contract specifies a certain wage w (s) and employment level L(s) for each s announced by the firm. 15.w (s). that is. ? 0).132 QUARTERLY JOURNAL OF ECONOMICS DEFINITION. to specify a random wage iv (s) and employment level L (s) conditional on the announcement s.. while when s < k the worker is unemployed and paid wu. once this announcement is made. Note that there is no moral hazard in such an arrangement. An optimal contract under asymmetric information is a pair (wuk).2) is the firm's expected utility. the firm can always increase profit by reducing wu.e. if not. Under such conditions. However. -wuEY. i. s < k s.w) = W(7ro. In the above.k) An optimal contract is one that maximizes the firm's expected utility subject to the worker's expected utility being at least U. which maximizes Ss k (2. the firm's actual profit will be a deterministic function of s. In particular. one can imagine that the firm earns profit 7ro elsewhere which is sufficient to cover its wage bill. L is discrete.e. it can be shown that stochastic contracts have no advantage over deterministic contracts.iV (s) a stochastic function of s.3) and (2.R) when employed and wu when unemployed. the insurance company will guarantee the firm a certain income of E[sL(s) .V(.2) subject to (2. Under (A1)-(A2).C(s)] in exchange for the firm giving the insurance company sL (s) . if at date 1 the firm announces that the state is s.. In the situation given in the text.G(k)) + U(wu)G(k) 2 U WUEf. (2.k)g(s) ds + V(-wu)g(s) ds U(wu + k . when the set of feasible employment and output levels is convex.3) will hold with equality. Expression (2.4) V(s . A contract when only the firm observes the state at date satisfying s < k < . Such schemes make the firm's profit sL (s) . so there is some benefit from randomization that will disappear when L is a continuous choice variable and the production function is concave. . Recently.R)(1 .Wu. since. Alternatively.14 1 is a pair (w. Maskin [1981] has shown that it may be desirable to make the contract stochastic. since the insurance is conditional on the announcement s and. DEFINITION.. note that it may be difficult to implement a random contract. Thus. if the worker cannot monitor (and hence prevent) such insurance. where the realization of &(s) and L(s) is determined by an objective lottery. there are k . (wu + k . We assume that V is defined for some levels of negative income (if W. (A1)-(A2) also ensure that as long as the constraint set is nonempty.3) gives the worker's expected utility.w>) for some function W. having signed such a contract.R)EY. where w(s). L (s) is the outcome of the lottery. where 7ro2 Wu. the firm will always wish to go to a (risk-neutral) insurance company and arrange that. i. the realization of L (s) and a(s) are determined by an objective lottery over which the firm has no control. that is. we have confined our attention to deterministic contracts. since when s > k the worker is employed and paid (k + wu).

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

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

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

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.R). is Weitzman [19801. (s) = U-. for max (s. For the remainder of the paper we shall assume that the firm does find it in its interest to make a contract with a worker at date 0. It is therefore natural to ask whether the probability of unemployment increases as the firm becomes more risk-averse.) Thus. Hence w. (k) + k . is analogous to the result that the marginal tax rate should be zero for the most able (see Sadka [1977]).17 III. for s > k > R. 17. (3. (Note that EV is decreasing in wu and in k. (k))G (k) = U.3) is increasing in w1. In order to answer this and other comparative statics questions.136 QUARTERLYJOURNAL OF ECONOMICS information is equal to the Walrasian level in the best state of nature. but may be increasing or decreasing in k (an increase in k raises the wage when employed but reduces the probability of employment).k. Proposition 1 is generalized to the case of a firm that employs many workers in Grossman and Hart [19811.R) < k < s.1) exceeds U when wu = w-. Finally. In this section we consider how this excess unemployment depends on the degree of risk aversion of the worker and firm. We know from the proof of Proposition 1 that.thatis. (R) = w. The firm's expected utility EV.R)(1 . we can draw indifference curves for the firm in Figure 1.2). = Clearly w. is also a function of wu. The model presented here is also an example of the principal-agent problem. given by (2. is differentiable for s > k > max(s.3) to write wu as a function of k: Wu=wu(k). We therefore use (2. if R > s. The left-hand side of (2.1) U(w. it is useful to investigate the constraint (2. Also. w. and that obtains comparative statics results for some special cases. . is as in Figure I.3) when there is equality.where U(MO) U (the existence of UT is guaranteed by (A3)).(k). A paper that adopts a somewhat similar approach to that taken here.G (k)) + U(w. Proposition 1 tells us that the probability of unemployment will exceed the Walrasian level only if the firm is risk-averse.and therefore wu(k) < 6-. the left-hand side of (3.

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

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

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

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

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

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

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

In particular.3) holds initially. (k . given an dition (5. (A) and (B) are fairly intuitive. an increase in rTL reduces the probability of unemployment. if SH.R)(1 .SL)/(SHextremely risk-averse firm and an approximately risk-neutral worker.R)). That is. ConR). (1 . then it will continue to hold if R increases. (SL . . If 7rL or (SL . Condition (5. In fact. unemployment will occur when s = SL. after a certain point.3) is unaffected. Thus. SL and R are all increased by the same proportion. if the firm is extremely riskaverse. 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.1).3) holds.R) constant and vary rjL. the expected efficiency loss that results from making s = SL an unemployment state is small. This is because by making s = SL an unemployment state the firm is able to reduce wages in this state.R) is small. the gain from improved risk sharing may be large. 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. Clearly. if k satisfies (5. the probability of the bad state. Similarly.R)(1 . For if (5.3) tells us that unemployment is more likely to occur in the bad state (A) the lower is the probability of the bad state. In particular. Note that in the limit when 7lL = ((SH ((SH . The probability of unemployment will then be rjL.Then we know from Proposition 10 that.144 QUARTERLY JOURNAL OF ECONOMICS satisfies k > SL. In contrast. if (5. (B) the lower is the net social return in the bad state relative to that in the good state.G(k))+ (see Proposition 6) is maximized at both k = SL and k = SH-18 That (k . as shown in Figure II.R). The probability of unemployment reaches its supremum as rL . V.G(k))+ has two maxi18.R)). then (5. 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.3) will hold for all irL < (SH .G(k))+ denotes the probability that s > k. Proposition 10 also enables us to determine for what two-point distribution the probability of unemployment will be highest.SL)/(SH SL)/(SH . we have a relationship between the probability of unemployment and 7rL. if (5. and this is very important to a highly risk-averse firm even if the probability of s = SL is low. while a proportionate change in s and R will lead to the same proportionate change in k.3) holds and the firm is sufficiently risk-averse and the worker is approximately risk-neutral. unemployment will occur for some U. then an increase in R can be shown to reduce k. the relationship is not monotonic. Suppose that we keep (SH .

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

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

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

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

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

Though Lucas [1972] and Barro [1976] consider models where "inefficient" unemployment occurs because of monetary nonneutrality. and this leads to labor supply fluctuations. Grossman. 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). For example. 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. 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. In particular. the above asymmetry implies that relative demand shocks decrease employment by more than they would under complete information. Further.E [x IInfo]. It is at the very essence of the model that labor supply response is asymmetric. Workers in a particular submarket have incomplete information about the real interest rate. 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] . we were able to show that the level of employment under asymmetric information equals the Walrasian level in the best state of nature. A model where the relative demand shocks are caused by wealth re20.150 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. . the driving variable that converts long-run inelastic labor supply into a short-run elastic labor supply is a variable like x . 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.E[r Iinfo]). In a model of relative demand shocks across industries. there are versions of Lucas' model where the driving shocks are real (not nominal) and the inefficiency in output also depends on expectational errors.20 In all of these models this is a symmetric variable. while bad states lead to non. Good states lead to Walrasian levels of unemployment.P). 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. Hart.Walrasian levels of unemployment. In all of these Lucas-like models. 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 . In linearized versions of Lucas' [1972] model such as Barro [1976].

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

U A Proof.W'k'. for a sufficiently large. a firm with utility function V prefers k = k (a) to k*. -w4) - max(s - . suppose that it is false.5) = 0 at k = k*. the first two terms are bounded.E. To establish the last part of the proposition.D. again by the proof of Proposition 2. while the third term goes to positive infinity. which says that. Proof of Proposition 3: Step 2. {EV(12) . As a goes to infinity. the firm's profit stream when k = k (a) will satisfy the single crossing property relative to the profit stream when k = k*. Hence k < k*. Wu (a)) (k wu (k) > wu(k*). this contradicts the fact that a more risk-averse firm (weakly) prefers (A. -wu) is negative for s < some s* and positive for s > s*.5) > 0. -K u) satisfies the single crossing property with respect to the distribution of max(s By Lemma 1.2)-(2. But LHS of (2. It follows that the distribution of max(s . for a large. Suppose that V(x) = -e > 0 for i 1.152 QUARTERLY JOURNAL OF ECONOMICS large s under (dIP) u(s) max(s - than under (&.. - .4).- k. It follows from Lemma 1 that a firm with utility function -e-a will prefer k = k (a) to k = k*. We show that if a person has constant absolute risk aversion of a sufficiently large size. Q.E. EV(11) < EV(I2). We shall need the following lemma.e. Suppose that I < 12. Then. Now dwu/dk = -RHS of (2.E. To prove (2). Q. Therefore. Proof of Proposition 3: Step 1. Then we can find a sequence of optimal k (a) converging to k < k* as a a) . then he will always choose the gamble with the higher minimum value. and so k = k* does not satisfy the first-order conditions for problem (2. one shows that k' = k violates the first-order conditions (2.Ik) and a less risk-averse firm (weakly) prefers (i. i. kI') to (i . Hence. the left-hand side of the expression is positive. w- k'. We have shown in Section II that k < k*.D. Let 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. Using the argument of the proof of Proposition 2.D. and I2 be two functions of s that are bounded above by a number b.I). Note that as a a ). But this contradicts Lemma 2./k) to (KIk).2. . Q. Let Ii infix Iprob(Ii < x) LEMMA2. since otherwise k (a) would not be preferred to k*.5). if a is sufficiently large. we may conclude that wu(k*) < w (k (a)) < wu (k (a)) + k (a) < wu (k*) + k*. a firm with utility function -e-at prefers the profit stream with the higher value in the worst state. By definition.

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

R)(1 = G(k)) is greater at k = s1 than at k = Sn.G (k*)) > (k .4). Thus.R)(1 .2) EU(R. But this means that L1 is riskier in the sense of Diamond-Stiglitz [1974] than L2. i.Si)/(Sn . Hence k < Sn. suppose that it does.G(k*))) and the lottery L2 = (wa (k) with probability G(k).R).R). w (k) + k . it follows that OEU/IR is larger the larger is k (since (ith Ck) + k) is increasing in k). Therefore.G(k))+ is maximized at k = Sn. That the same is true if the worker is approximately riskneutral follows from a continuity argument. Since we know that EU(R. Suppose that k' < k.7r?) = (Sn .( . where Cvu is decreasing in k and (vu (k) + k) is increasing (k) in k.k) __5_R_ = -U'(vu (k) + k - R)(1 -G (k)).R with probability (1 . wu(k*)G(k*) + (wu(k*) + k*. and so a risk-neutral worker will prefer L1 to L2. Proof of Proposition 11. it follows that w.k) = U('u(k))G(k) + U(wu(k) + k - R)(1 - G(k)). To prove (2).5).R)(1 . Proposition 3(2J tells us that there exists a such that (-V"(w )/V'(ir)) > a ==k . for the probability of unemployment to exceed (Sn . Hence we may write the worker's expected utility as (A. the probability of unemployment can be made arbitrarily close to (1 . Q. note that if the worker is risk-neutral. This contradicts the definition of k.which solves (5. (k*) with probability G(k*). Differentiate (A.k') (I is initially optimal). As in the proof of Proposition 4.R).R)(1 . weLk*) + k* -R with probability I .R)(1 -G(k*)) > wu(k)G(k) + (wu(k) + k - R)(1 -G(k)) which implies that (k* . I' = fIviolates the first-order conditions (2.R).R.k I < e.R). k < sn-1. Thus. we can ensure that (k .154 QUARTERLY JOURNAL OF ECONOMICS function U. since wu(k*) < wu(k). we must have -rn < (s . This yields (A.G (k)). .ik) ' EU(R. Since the probability of employment is lower under L1. Note that by Proposition 1(1) we always have employment when s = Sn. it follows that EU(R + a. This shows that employment will (R+ a).e.E. By choosing 7rclose to the 7r.R)/(sn . The latter constraint may be used to solve for wu = Jv (k).G(k)) cannot reach a maximum except at a mass point. But this means that a risk-averse worker with utility function U is indifferent between the lottery L1 = (w.. To show that the probability of unemployment cannot exceed (Sn . But then (k . But this contradicts the fact that I' is optimal under This proves that I' ' I. since (k .G (k))). (k*) + k* .S)/(Sn . 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. From this. Finally. Proof of Proposition 8.3) (R.k) > EU(R + ak') given that k > k'.2) with respect to R.D.R > wu(k) + k .Si)/(Sn .

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