Topic 4: A Contract Theory of Layoffs and Unemployment

While the previous theoretical sketches explain many common features of cyclical unemployment they give us no understanding of why firms lay workers off in recessions and refuse to hire people willing to work at or below the wages currently being paid. We now turn to the development of a contract theory that will explain this phenomenon. Our theory will contain relevant features of the several contract theories that have been devised by economists in the past.

The fundamental feature of contract theories is that firms and workers make an implicit contract by which the firm will guarantee its employees, once they have obtained sufficient seniority, continuous employment at a real wage rate that is invariant to changes in market conditions. In return, the employees agree to work for wages that are lower than they would require if stability of employment and wages were not guaranteed. As a consequence of such contracts, firms lay off junior workers in recessions and hire them back in booms. Our first concern is to understand why workers and firms would make such contracts and how those contracts are enforced.

Most workers have large fractions of their wealth invested in their human skills---if the market for those skills goes bad their income will decline drastically. Workers will pay a price in terms of wages to achieve income stability. The owners of firms, on the other hand, have ample opportunity to diversify their wealth-holdings across a wide portfolio of assets. They can thus acquire somewhat reasonable security of income by sharing ownership in a number of firms and holding part of their wealth in bonds and fixed-income assets. Unforeseen losses on some assets will thus tend to be offset by unforeseen gains on others.

Given that workers cannot diversify their wealth-portfolios as well as can the owners of firms, it is in their interest to make deals with their employers. The owners of firms can gain by absorbing increased variability of profits, which they can diversify away by holding a wide variety of assets, in return for maintaining stable levels of employment at steady but suffiently lower wages to achieve higher long-run average profit levels. And workers thereby achieve security by accepting lower wages.

The security workers buy in this way will frequently extend well beyond the mere stabilization of wages across booms and recessions, encompassing pension plans, paid sick leave, medical insurance, and so forth. Indeed, even when there are no labour unions firms typically take pains to ensure that no one is fired without good reason and that promotions are based on performance, not friendships. They do this in part to minimize risk for their employees and thereby be able to hire workers at wages that are lower in compensation for the greater financial security they provide. It is thus possible for workers to purchase, in return for accepting lower wages, insurance against unforeseen events and arbitrary behaviour of their employers that could not otherwise be purchased in the market.

But how are these contracts enforced? Contractual details are difficult to write down because many aspects of the relations between employers and employees depend on common sense and good judgment and cannot be measured on a quantitative scale. What is to stop an employer from paying low wages in the understanding that job security will be provided, and then dumping a worker on some pretext when conditions change and there is immediate gain from abrogating the contract? The main reason a firm would not behave in this way is that word would get around among current and prospective employees and the firm would no longer be able to hire good workers at low wages. The contract is an implicit one, enforced not by courts of law but by the needs of firms to maintain their reputations. For this reason such contracts are often called quasi-contracts.

We can now analyze the implications of these contracts for employment levels over the business cycle. The contracts are designed to protect workers against a wide variety of unforseen shocks, not just cyclical changes in demand. They protect against obsolescence of skills, in which case the employer would pay for retraining or shift the worker to a job that he/she could handle, without reduction in salary. But they do not protect workers against their own incompetence if clearly established. Also, when the survival of the firm is in jeopardy an alteration in the terms of the contract will be widely perceived as justified---the reputation of a failed firm is worthless in any event.

These implicit contracts are, of course, based on real, not nominal, wages. So if everyone knows that there is a downward shock to aggregate demand which lowers equilibrium nominal wages and prices by 10 percent, nominal wages will be immediately adjusted downward by that amount with the agreement of all concerned. This can be seen in Figure 1 which portrays the situation for a typical firm. Due to a shift in aggregate demand in the economy as a whole the firm's demand for labour shifts from  D1D1  to  D2D2.  Nominal wages fall immediately from  W1  to  W2  with employment unchanged. It follows that nominal wages will be constantly adjusted by the expected inflation rate in the economy as was the case in our previous auction and search models.

Figure 1

Suppose now that economy-wide changes in aggregate demand occur that are perceived either as temporary economy-wide changes or temporary firm-specific changes. Firms have contractual reasons not to make wage adjustments in response to these shifts. Analysis can proceed with reference to Figure 2. Suppose that demand shifts alternately between  D1D1  and  D2D2. The firm will hold wage rates constant at some average level  W0  reflecting the average level of demand and vary employment between  Q1  and  Q2.  Were the firm to vary wages, workers would vary employment offered along the supply curve  SS.  This supply curve is drawn with the understanding that all other firms in the industry, and the whole economy, would be making the same wage adjustments in response to the same shocks to their demand curves for labour.

Figure 2

Instead of varying wages, however, the firm adjusts employment by laying off and rehiring workers at a fixed wage rate reflecting its estimate of long-term market conditions. As a result the value marginal product of labour, measured by the distance between the demand curve and the horizontal axis, is below the wage rate in periods of slack demand and above it in periods of excessive demand, as shown by the thick line-segments at points  c  and  b . A crucial part of the argument is that workers are indexed along the horizontal axis by seniority, starting with the most senior worker at the origin with increasingly less senior ones out along the axis to the right. As the firm varies employment between  Q1  and  Q2  less senior workers are layed off first and rehired last. This is in contrast to the movement along the SS curve where workers would vary their labour supply according to the aggregate of individual preferences.

The firm could increase its current-period profits by hiring less workers than  Q2  in bad times and more workers than  Q1 in good times. But this would in fact lower its long-run profits because it would then have to pay a wage rate above  W0  to compensate its workers for the greater uncertainty of income and employment. In effect, the firm is making life-time contracts with its employees, guaranteeing them reasonable treatment along with increased income stability as seniority is acquired. It is in its interest to do so because the average level of wages it will have to pay will then be less.

The contract theory just developed explains why firms lay off workers in recessions. Even if everyone knows that the level of nominal aggregate demand is below normal, it pays for layoffs to occur instead of wage cuts to provide income stability for the more senior workers. And in periods when aggregate demand is temporarily high, it pays firms to maintain wage stability, rehiring workers that they had layed off in previous slack periods or hiring new workers who will accept the current wage in order to build up seniority. It should now be obvious that the contract theory explains why workers do not quit their jobs in recessions. Moves between jobs occur in boom periods when firms are hiring.

Under the auction and search theories, a crucial feature of unemployment rate fluctuations was missinformation about the state of aggregate demand. Under the contract theory, employment will fluctuate around its natural level even if the state of aggregate demand is always known. Of course, the unemployment rate will also fluctuate under the contract theory in response to unforseen shocks to aggregate demand.

When there is a permanent change in the equilibrium rate of inflation in the economy, the time path of nominal wages will respond immediately when the change is known and there are quasi-contracts between firms and workers because there is no incentive to delay the path of nominal adjustment. But with union contracts that are in writing there may be an incentive on the part of one or both parties to not renegotiate previously agreed-upon multi-year wage rate provisions. When workers and firms do not realize that fundamental changes in the inflation rate are occurring, there is a further reason for nominal wage adjustment to be delayed.

It is test time. Be sure to think up your own answers before looking at the ones provided.

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