Debt and Wage Negotiations: A Bankruptcy-Based Approach

Abstract

The role of debt in wage negotiations is considered in a framework where both the entrepreneur and the workforce are indispensable in production. When workers and the entrepreneur fail to reach an agreement, the firm eventually defaults. Bankruptcy is represented as a three-party bargaining game among the entrepreneur, workers and lenders. We show that debt financing, by reducing workers' bargaining power, increases the firm's share of surplus and improves the incentives to invest. Further, our model allows for overborrowing (the firm borrows more than required by its productive activity), as well as underinvestment due to wealth constraints. I. Introduction As asserted by Grout (1984), the inability of labour unions to make wage commitments creates an underinvestment problem: when wages can be negotiated after investment has been sunk, the entrepreneur chooses an inefficiently low investment level. In this paper we reconsider Grout's underinvestment problem by concentrating on the role of debt in wage bargaining when long-term labour contracts cannot be written.' As we show through an explicit analysis of the threat of bankruptcy, the extent of underinvestment depends on whether leverage can influence the distribution of surplus between wages and profits. We analyse the relation between debt and wages in a strategic bargaining framework, assuming that delays in agreement will reduce the surplus