Implicit Contracts, Moral Hazard, and Unemployment

Abstract

This paper considers a firm whose marginal (revenue) product of labor is a random variable. We derive the form of an optimal long-term contract between workers and the firm under the assumption that labor's marginal product is observed by the firm but not by the workers. We show that the existence of asymmetric information causes unemployment to be greater than in a situation where information about labor's marginal product is public, or where employment is determined in spot markets. In particular, unemployment can occur when the marginal product of labor exceeds the reservation wage.

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