Involuntary Unemployment and Worker Moral Hazard

Abstract

This paper critically examines the hypothesis that layoffs are involuntary in implicit labour contracts because they are used by employers to punish inferior worker performance. In repeated moral hazard situations, workers typically bear risk associated with whether they'are chosen to be laid off even though the latter is uninformative about previous effort choices and wages are performance-contingent. However the hypothesis is unsatisfactory as optimal contracts involve involuntary retentions rather than involuntary layoffs in a wide variety of circumstances. The theory of implicit labour contracts as developed over the past decade has thrown considerable light on the nature of long-term employment relationships. By emphasizing that firm owners are usually less risk-averse than workers and thus have an incentive to insure workers against fluctuations in the demand for the firm's product, the theory manages to explain the emergence of long term contracts characterized by (downward) real wage rigidity (see Holmstrom (1983)). However the theory also typically implies that workers will be indifferent about whether they are to be retained or laid off. This runs contrary to the common observation that there is an element of involuntariness in layoff decisions, i.e., within any job category (with given skill and performance history) if a proportion of randomly chosen workers are to be laid off in a recession, the laid off workers would strictly prefer to be retained. Not only is this phenomenon of involuntary layoffs interesting to explain per se, it also seems relevant to the Keynesian notion of involuntary unemployment (interpreted as unequal treatment of similar workers where some are employed while others are not, and unemployed workers would strictly prefer to be employed). It thus seems worthwhile to examine if the theory of implicit contracts can be extended to explain this phenomenon satisfactorily as a test of its plausibility, and as a possible source of a consistent microfoundation for Keynesian propositions.! To explain why the firm does not insure workers against the risk associated with selection of those to be laid off, it is natural to think of possible informational asymmetries. This has been attempted by Geanakoplos and Ito (1981) and Moore (1985). Geanakoplos and Ito introduce the realistic feature that a firm does not observe spot market opportunities available ex post to a laid off worker. This permits only incomplete insurance against the risk of layoff. However their model produces the paradoxical conclusion that with decreasing absolute risk aversion, workers strictly prefer ex ante being laid off. Moore allows workers to have better ex ante information about their spot market opportunities, but finds a similar tendency toward involuntary retentions rather than involuntary layoffs. In this paper we explore the alternative hypothesis that firms cannot perfectly observe effort decisions of employed workers, and use the threat of involuntary layoff as a discipline device. The analysis of Stiglitz and Weiss (1983), Shapiro and Stiglitz (1984) and Singh (1982) of principal-agent relations in the absence of demand fluctuations suggests that the threat of contract termination may be used as an incentive device. In their models