Relational Contracts and On-the-Job Search

This paper characterizes the distribution of jobs in a relational contracting model where underemployed workers compete with unemployed workers in the job market. Such on-the-job search increases turnover and thereby the marginal costs to incentivize effort. This leads firms to replace permanent jobs that pay high wages and command high effort, with temporary jobs that pay low wages and command low effort. This deterioration of job quality reduces the prospects of the unemployed and introduces slack into the workers' incentive constraints. If the number of firms is fixed, firms react by cutting wages, so profits increase while welfare and workers' rents decrease. If the number of firms is endogenous, new firms enter the market, so the loss of high-quality jobs is countered by an increase in the total number of jobs. When unemployed and underemployed workers' are equally skilled in getting job offers, free entry leads to full employment and effort is incentivized by the threat of underemployment rather than unemployment.