Monitoring cost, agency relationships, and equilibrium modes of labor contracts

Abstract

In this paper, we attempt to give an economic explanation for differences in institutional framework between Japan and Western countries. We propose that the differences may be created because economies sometimes have multiple equilibria, each of which is characterized by a different institutional norm. Thus, differences in institutional framework that exist between different societies may be ascribed neither to the difference in “cultures” nor to underlying behavioral norms or parameters. Particularly, we investigate why and how different modes of economic relations arise in a labor market when work incentive is a crucial factor in labor management. Like many other papers in this field, this paper shows that there may be involuntary unemployment in order to create a threat of dismissal for workers who shirk their duties. One novelty of the current paper lies in the fact that, by introducing an immediate penalty to those workers who are found shirking, equilibrium labor contracts may not be of the form in which contracts are automatically renewed as long as workers are not found shirking. Thus, our economy is found to be characterized either by long-term labor contracts with involuntary unemployment or by short-term labor contracts with no unemployment, depending upon the value of underlying parameters. We identify the factors which make firms choose different labor contracts, and perform comparative statics. Moreover, we show that the economy normally has two equilibria, the one described above and the other characterized by long-term labor contracts with no unemployment. Work incentive is created by the belief that dismissed workers will not find new jobs. The latter type of equilibrium is proved to be Pareto superior. The implications of multiple equilibria in such a framework are discussed.