A Model of Involuntary Unemployment and Wage Rigidity: Worker Incentives and the Threat of Dismissal

Abstract

This paper analyzes a model that highlights imperfect monitoring and the threat of dismissal as microeconomic underpinnings for the efficiency-wage hypothesis. My major innovation is to allow the rules for dismissal as well as the wage to be determined endogenously as the equilibrium of a Stackelberg game played between firms and workers. The key results are as follows. A nontrivial equilibrium (where positive output is produced) must involve involuntary unemployment in that employed workers are strictly better off than are the unemployed. In addition, the equilibrium wage is rigid with respect to exogenous shifts in productivity.

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