Efficient Labor Contracts with Employment Risk

Abstract

This article analyzes efficient employment agreements where the demand for consumption insurance can be satisfied by noncontractual means. We assume that workers can save and that consumption is determined by a strong form of the permanent income hypothesis. Under conditions of asymmetric information about exogenous shocks to labor demand, we derive a unique compensation schedule that efficiently guides decisions by both workers and employers. Efficient employment outcomes are generated without a need for third-party enforcement or monitoring, and workers choose a consumption policy that leaves them indifferent among realizations of labor demand. Within this solution it is both costless and efficient for workers to delegate employment decisions to the firm. Within the context of the model we analyze implications for the equilibrium distribution of wages and for empirical studies of labor supply.