The simultaneous occurrence of (ex post) involuntary unemployment and underemployment is explained by strategic contracting of firms operating in oligopolistic product markets. Firms have an incentive to offer labor contracts in which wage payments (net of opportunity costs of labor) exceed layoff payments. Such contracts increase marginal costs in bad states, thus relaxing price competition in the product market. In equilibrium, this strategic incentive leads to inefficiently low expected employment, inefficiently high use of other inputs, and inefficient risk bearing by workers relative to the cost minimizing solution. When the product market becomes fragmented, the distortions in the input markets disappear. Copyright 1994 by Royal Economic Society.
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