Implicit Contracts: a Survey

Abstract

7mplicit contracts resolve the distribution of uncertainty and utilization of specific human capital between risk averse workers and less risk averse firms. Incomplete contracts are required to yield involuntary layoffs in contract markets: otherwise, contracts are efficient and pareto optimal by construction. There is a close relation between contract theory and neoclassical labor market theory. Contracts smooth consumption, but increase the volatility of labor supply and labor utilization to demand disturbances, because contractural insurance eliminates the income effects of socially diversifiable risks. This result is similar to the intertemporal substitution hypothesis. However, the price mechanism in a contract is substantially different. Contracts embody a nonlinear two-part pricing scheme. The lump sum part allocates the income-consumption consequences of risks and the marginal pricing part allocates production and labor utilization. This implicit pricing mechanism is in all respects "flexible," though the observed average hourly wage combines both parts and may give the outward appearanceof rigidity. Furthermore, the observed average wage rate in a contract does not reflect marginal conditions necessary for structural econometric estimation. Indivisibilities appear necessary to account for the split between work-sharing and layoffs. Contracts with private information are also considered in the nonlinear pricing context.