Incomplete Self-Enforcing Labor Contracts

We consider a model economy populated by risk-neutral …rms with multiple jobs and riskaverse workers. Following the implicit contract literature, we assume that workers have limited access to the intertemporal trade markets. Following the directed search literature, we assume that unemployed workers can choose which …rms to visit after having observed what terms of trade are o¤ered. Further, we assume that the participation to an employment relationship must be self-enforcing and that contractual prescriptions cannot be contingent upon the job title. Under these two restrictions on the contract space, …rms face a trade-o¤ between the e¢ cient provision of insurance to its senior workers and e¢ cient recruitment of junior hires. We characterize the ex-ante contractual solution to this trade-o¤. We …nd that the optimal contract prescribes that— in response to small and negative shocks to …rm’s productivity— the wage paid to senior employees is set equal to the wage o¤ered to junior employees. This …rm-wide wage is greater than the ex-post e¢ cient hiring wage and lower than the full-insurance wage. In general equilibrium, we …nd that these distortions lead to a larger increase in the unemployment rate in response to a negative shock to aggregate productivity. We have greatly bene…ted from the input of Dale Mortensen, Ken Burdett, Robert Hall, John Knowles, Chris Pissarides, Guillaume Rocheteau, Randy Wright, and from our audience at Stanford University, the LSE, the Norwegian School of Management and at the February 2006 Search and Matching conference at the University of Pennsylvania.