Optimal Labour Contracts and Involuntary Unemployment under Costly and Imperfect Monitoring

Abstract

This paper provides an explanation for the concurrence of rigid wages and involuntary unemployment. We consider cases in which a firm monitors its workers, but at some cost. A key assumption in the model is that the firm cannot perfectly distinguish shirkers from nonshirkers. Thus, the firm has to rely on negotiated compensation and work effort, as well as monitoring, to reduce the incentive to shirk. We find that rigid wages and involuntary unemployment arise simultaneously when monitoring costs are large and the effectiveness of monitoring is low.