Abstract
This paper examines the contract between a risk-neutral firm and its risk-averse employees, assuming that worker ability is privately learned by the firm after a period of employment. Employers in an external spot labour market attempt to infer worker quality from the observable actions taken by the firm (such as the number of workers it lays off). The threat of spot market raids distorts the optimal contract. Layoffs may be involuntary and can exceed efficient levels. A seniority layoff rule may be included in the contract to avoid the adverse selection problems that arise if layoffs are conducted on the basis of ability.
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