Contract and Rent Dispersion in a Frictional Labor Market

Abstract

This paper incorporates a risk-neutral principal-agent model with contractual constraints into a random search model to study the interaction between contracting and search in partial and general equilibrium. I introduce heterogeneity in principals' and agents' production technologies in terms of the distribution of output across states of nature and characterize equilibrium in this context. Principals tailor contracts to agents' production technologies to incentivize agents' effort, generating dispersion in optimal contracts. The resulting endogenous dispersion in agency rents introduces an option value of search, which can generate inefficient equilibria with lengthy search and a persistent fraction of unmatched principals and agents. I show that a reduction in search costs and contractual innovations can reduce welfare. The results have implications for labor and financial economics and imply a novel theory of specialization in decentralized markets.