Employment Insurance and Competitive Equilibrium Labour Contracts

Abstract

It is now recognized that risk-trading between risk-neutral firms and riskaverse workers, the central theme of implicit contract theory (Azariadis, 1975; Baily, 1974; and Gordon, 1974), is sufficient (but not necessary) to rationalize wage rigidity but is absolutely inconsequential in explaining layoffs. Rather, it is solely the existence of non-trivial value of leisure and/or outside unemployment compensation that causes workers to prefer the layoff contract' over the full-employment alternative (e.g. Akerlof and Miyazaki, 1980; Pissarides, 1981). Thus, while risk-trading per se leads to a contractual labour market, the added assumption of differential risk attitudes between riskneutral firms and risk-averse workers plays a negligible role in rationalizing the joint phenomena of wage rigidity and layoffs. In this paper, it is argued that the strong assumption that all firms are risk-neutral should be abandoned2 for the following reasons. First, it can be shown to be neither necessary nor even sufficient for the existence and efficiency of the fixed-wage/variable-employment (i.e. wage rigidity-cumlayoff) contract. Second, short of perfect negative correlation between profits of different firms (which rules out macroeconomic risks), shareholders generally cannot diversify away all risks. Third, the presence of transactions costs or inherent differences in information between economic agents suggests that shareholders would differ in their ability to diversify away their risks. Finally, it is not even clear whether shareholders' preferences should be of concern; the property rights definition of the firm (e.g. Fama, 1980) indicates that shareholder ownership should be separated from management control, thus making managerial preferences the focus of attention. For all these reasons, we find it necessary in this paper to extend the implicit-contract model to accommodate firms with varying degrees of risk aversion. In particular, we shall demonstrate the properties of the equilibrium contract structure when risk-neutral and risk-averse firms coexist. Furthermore, we also analyse the interesting question of how increasing uncertainty will affect the various equilibrium contracts. The interest of this exercise is due to the fact that existing works that do consider risk-averse firms (e.g. Akerlof and Miyazaki, 1980, and Grossman and Hart, 1981) have not proceeded further than the well-known observation that replacing risk-neutral firms with risk-averse firms simply implies that, in equilibrium, a variable-wage (across states of nature) contract would replace the fixed-wage contract. But, at the same time, coexistence of both classes of contracts is commonly observed in any economy. Hence it is essential to consider a model capable of explaining such a phenomenon.