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On Implicit Contracts and Involuntary Unemployment

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Abstract

We show that a firm can increase expected profits by undertaking the additional expense of paying unemployment compensation to the workers it lays off, if they are risk averse. When this argument is applied to the implicit contract models it makes the involuntary unemployment derived there disappear, where by involuntary unemployment we mean a situation in which one worker has a job at a wage w and another worker who is known to be productively identical and willing to take on the job at a lower wage h cannot find a job. We introduce into our model asymmetric information between sectors of the economy. Each agent knows the state of his own firm but not that of others. We suppose also that workers have specific skills which are conformable to some, but not all, firms in the economy. In this model we reestablish the phenomenon of involuntary unemployment in a general implicit contracts equilibrium in which the proportion of layoffs, the "stabilized" wage, and the severance payments are endogenously determined. Moreover, we show that the presence of involuntary unemployment is a signal that there is too little output in the most productive sectors of the economy, thereby restoring the link between underproduction and involuntary unemployment missing in the implicit contracts literature. Finally we ask how large should be the severance payment a profit maximizing firm gives to each worker from a branch it shuts down, when there is uncertainty about what jobs those workers will find. We prove that the rational expected-profit-maximizing firm will offer a contract which provides severance compensation so generous that on average the workers dismissed by the closing of a plant can expect to be better off than if they had been retained, in the case that they have decreasing absolute risk aversion.

Suggested Citation

  • John Geanakoplos & Takatoshi Ito, 1982. "On Implicit Contracts and Involuntary Unemployment," Cowles Foundation Discussion Papers 640, Cowles Foundation for Research in Economics, Yale University.
  • Handle: RePEc:cwl:cwldpp:640
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    File URL: http://cowles.yale.edu/sites/default/files/files/pub/d06/d0640.pdf
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    1. George A. Akerlof & Hajime Miyazaki, 1980. "The Implicit Contract Theory of Unemployment meets the Wage Bill Argument," Review of Economic Studies, Oxford University Press, vol. 47(2), pages 321-338.
    2. Gordon, Robert J., 1976. "Recent developments in the theory of inflation and unemployment," Journal of Monetary Economics, Elsevier, pages 185-219.
    3. H. M. Polemarchakis, 1979. "Implicit Contracts and Employment Theory," Review of Economic Studies, Oxford University Press, vol. 46(1), pages 97-108.
    4. Grossman, Sanford J & Hart, Oliver D, 1981. "Implicit Contracts, Moral Hazard, and Unemployment," American Economic Review, American Economic Association, vol. 71(2), pages 301-307, May.
    5. Radner, Roy, 1979. "Rational Expectations Equilibrium: Generic Existence and the Information Revealed by Prices," Econometrica, Econometric Society, vol. 47(3), pages 655-678, May.
    6. Allen, Beth E, 1981. "Generic Existence of Completely Revealing Equilibria for Economies with Uncertainty when Prices Convey Information," Econometrica, Econometric Society, vol. 49(5), pages 1173-1199, September.
    7. Hall, Robert E & Lilien, David M, 1979. "Efficient Wage Bargains under Uncertain Supply and Demand," American Economic Review, American Economic Association, vol. 69(5), pages 868-879, December.
    8. Gordon, Donald F, 1974. "A Neo-Classical Theory of Keynesian Unemployment," Economic Inquiry, Western Economic Association International, vol. 12(4), pages 431-459, December.
    9. Imai, Haruo & Geanakoplos, John & Ito, Takatoshi, 1981. "Incomplete insurance and absolute risk aversion," Economics Letters, Elsevier, vol. 8(2), pages 107-112.
    10. Bengt Holmstrom, 1980. "Equilibrium Long-Term Labor Contracts," Discussion Papers 414R, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    11. Martin Neil Baily, 1974. "Wages and Employment under Uncertain Demand," Review of Economic Studies, Oxford University Press, vol. 41(1), pages 37-50.
    12. Azariadis, Costas, 1975. "Implicit Contracts and Underemployment Equilibria," Journal of Political Economy, University of Chicago Press, vol. 83(6), pages 1183-1202, December.
    13. Polemarchakis, Heraklis M & Weiss, L, 1978. "Fixed Wages, Layoffs, Unemployment Compensation, and Welfare," American Economic Review, American Economic Association, vol. 68(5), pages 909-917, December.
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    Cited by:

    1. Rosen, Sherwin, 1985. "Implicit Contracts: A Survey," Journal of Economic Literature, American Economic Association, vol. 23(3), pages 1144-1175, September.

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