Implicit Contracts
Do They Explain Unemployment?

Economists have found it difficult to explain involuntary unemployment adequately with conventional analysis. This has prompted various efforts to modify the theory so that it can account for such unemployment. Recent attempts fall into two main categories - implicit contract theories and 'efficiency' wage models, in which the productivity of the firm's labour force depends on the wage it pays. Both theories purport to explain wage rigidities; these inflexible wages in turn prevent the labour market from clearing and so lead to unemployment. In the efficiency wage models, firms do not lower wages, even in the face of unemployment, because to do so lowers the productivity of their workers. In the implicit contract theories, risk-neutral firms insure risk-averse workers against fluctuations in workers' marginal productivity by maintaining stable wages.

Though involuntary unemployment has often been ascribed to wage rigidities, such inflexibility by itself may not be sufficient to generate unemployment. In Discussion Paper No. 67, Joseph Stiglitz and CEPR Research Fellow David Newbery attempt to identify circumstances under which implicit contracts will give rise to unemployment. In particular, they investigate the implications of some important features of implicit contracts and firms' economic environment which earlier research did not adequately recognize.

Implicit contract theory assumes that the workers and the firm sign a contract which maximizes the expected profits of the firm, provided that the workers' expected utility under the contract is high enough to induce them to work for the firm. Newbery and Stiglitz argue that insufficient attention has been paid to (i) the general equilibrium consequences of these decisions; and (ii) the set of feasible contracts.

They construct a simple general equilibrium model which explores three restrictions on the implicit contracts which could be drawn up between workers and firms:

(i) Information: implicit contracts can only be written on the basis of information which is available or can be inferred by the workers and the firm; explicit contracts require, in addition, that any contingency provision be observable to an outside party. Newbery and Stiglitz therefore distinguish between verifiability and observability.

(ii) Enforcement: implicit contracts differ from explicit contracts in that there is no legal mechanism for enforcement. Two alternatives are available: reputation mechanisms, where bad behaviour of the firm is punished by increasing the cost of future recruitment, and self-enforcement mechanisms, where bad behaviour of the firm is punished by the withdrawal of effort of current workers. Both require long-lived firms. The analysis of these enforcement problems provides a critical link between efficiency wage and implicit contract theories: just as efficiency wage theory argued that lowering wages might lower profits by lowering workers' net productivity, Newbery and Stiglitz argue that abrogating an implicit contract may lower profits by increasing recruiting costs and reducing workers' effort.

(iii) Complexity: in practice contracts are not economically very complex; they are usually not made contingent upon even the more important variables that economic theory suggests are relevant. Newbery and Stiglitz argue that the problems of reaching an agreement over a complex implicit contract and then enforcing it are even greater than those involved in explicit contracts.

They first show that in the absence of problems of observability, enforcement, and complexity, implicit contract theory, though explaining wage rigidity, will not give rise to unemployment.

Newbery and Stiglitz then examine what happens when one or more of these problems is introduced. They show that natural restrictions on enforceability alone or on the degree of complexity alone do not lead to unemployment. Limited observability may lead to unemployment, though under conditions which the authors find unconvincing. The presence of two or more of these problems does give rise to unemployment. In particular, Newbery and Stiglitz find that restrictions on the complexity of a contract and its enforceability may lead to periodic unemployment.


Wage Rigidity, Implicit Contracts, Unemployment and Economic Efficiency
D M Newbery and J E Stiglitz

Discussion Paper No. 67, June 1985 (ATE)