Optimal Labour Contracts when Workers have a Variety of Privately Observed Reservation Wages

Abstract

If a firm does not know the individual ex post outside opportunities of its contracted workforce, then it can use hours, wages, and redundancy payments to screen them. Will a second-best contract have underemployment inefficiency, or overemployment? And, with a stochastic contract, are those workers randomly selected for layoff worse off than their retained colleagues (involuntary layoff), or vice versa (involuntary retention)? The answers depend on the nature of the workers' preferences. Two polar cases are looked at, corresponding to permanent and temporary layoff. The former is characterized by overemployment and involuntary retention; the latter by underemployment and involuntary layoff. Also examined are simple contracts, where all retained workers are paid a common wage and all laid-off workers receive a common redundancy payment. Handling asymmetric information in stochastic contracts has led to two technical innovations. First, a number of results are proved even though all the truth-telling constraints are explicitly included. Second, a new regularity condition is found under which the local constraints are sufficient to ensure global incentive compatibility at an optimum.