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Efficient Labor Contracts with Employment Risk

  • Robert H. Topel
  • Finis Welch

This article analyzes efficient employment agreements where the demand for consumption insurance can be satisfied by noncontractual means. We assume that workers can save and that consumption is determined by a strong form of the permanent income hypothesis. Under conditions of asymmetric information about exogenous shocks to labor demand, we derive a unique compensation schedule that efficiently guides decisions by both workers and employers. Efficient employment outcomes are generated without a need for third-party enforcement or monitoring, and workers choose a consumption policy that leaves them indifferent among realizations of labor demand. Within this solution it is both costless and efficient for workers to delegate employment decisions to the firm. Within the context of the model we analyze implications for the equilibrium distribution of wages and for empirical studies of labor supply.

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Article provided by The RAND Corporation in its journal RAND Journal of Economics.

Volume (Year): 17 (1986)
Issue (Month): 4 (Winter)
Pages: 490-507

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Handle: RePEc:rje:randje:v:17:y:1986:i:winter:p:490-507
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  1. Altonji, Joseph G, 1982. "The Intertemporal Substitution Model of Labour Market Fluctuations: An Empirical Analysis," Review of Economic Studies, Wiley Blackwell, vol. 49(5), pages 783-824, Special I.
  2. Azariadis, Costas, 1975. "Implicit Contracts and Underemployment Equilibria," Journal of Political Economy, University of Chicago Press, vol. 83(6), pages 1183-1202, December.
  3. Flavin, Marjorie A, 1981. "The Adjustment of Consumption to Changing Expectations about Future Income," Journal of Political Economy, University of Chicago Press, vol. 89(5), pages 974-1009, October.
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  5. Holmstrom, Bengt, 1981. "Contractual Models of the Labor Market," American Economic Review, American Economic Association, vol. 71(2), pages 308-13, May.
  6. Milton Friedman, 1957. "A Theory of the Consumption Function," NBER Books, National Bureau of Economic Research, Inc, number frie57-1.
  7. Daniel S. Hamermesh, 1980. "Social Insurance and Consumption: An Empirical Inquiry," NBER Working Papers 0600, National Bureau of Economic Research, Inc.
  8. MaCurdy, Thomas E, 1981. "An Empirical Model of Labor Supply in a Life-Cycle Setting," Journal of Political Economy, University of Chicago Press, vol. 89(6), pages 1059-85, December.
  9. Lucas, Robert E, Jr & Rapping, Leonard A, 1969. "Real Wages, Employment, and Inflation," Journal of Political Economy, University of Chicago Press, vol. 77(5), pages 721-54, Sept./Oct.
  10. Kahn, Charles M. & Green, Jerry, 1983. "Wage-Employment Contracts," Scholarly Articles 3203642, Harvard University Department of Economics.
  11. Bewley, Truman, 1977. "The permanent income hypothesis: A theoretical formulation," Journal of Economic Theory, Elsevier, vol. 16(2), pages 252-292, December.
  12. Hall, Robert E, 1978. "Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence," Journal of Political Economy, University of Chicago Press, vol. 86(6), pages 971-87, December.
  13. Gordon, Donald F, 1974. "A Neo-Classical Theory of Keynesian Unemployment," Economic Inquiry, Western Economic Association International, vol. 12(4), pages 431-59, December.
  14. Grossman, Michael, 1973. "Unemployment and Consumption: Note," American Economic Review, American Economic Association, vol. 63(1), pages 208-13, March.
  15. Akerlof, George A & Main, Brian G M, 1981. "An Experience-Weighted Measure of Employment and Unemployment Durations," American Economic Review, American Economic Association, vol. 71(5), pages 1003-11, December.
  16. Grossman, Sanford J & Hart, Oliver D, 1981. "Implicit Contracts, Moral Hazard, and Unemployment," American Economic Review, American Economic Association, vol. 71(2), pages 301-07, May.
  17. Hart, Oliver D, 1983. "Optimal Labour Contracts under Asymmetric Information: An Introduction," Review of Economic Studies, Wiley Blackwell, vol. 50(1), pages 3-35, January.
  18. Heckman, James J, 1974. "Life Cycle Consumption and Labor Supply: An Explanation of the Relationship Between Income and Consumption Over the Life Cycle," American Economic Review, American Economic Association, vol. 64(1), pages 188-94, March.
  19. Rosen, Sherwin, 1983. "Unemployment and insurance," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 19(1), pages 5-49, January.
  20. Yaari, Menahem E., 1976. "A law of large numbers in the theory of consumer's choice under uncertainty," Journal of Economic Theory, Elsevier, vol. 12(2), pages 202-217, April.
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