Testing the Efficiency of Employment Contracts

Abstract

The recent literature on employment contracts emphasizes that it is in the interests of the parties to produce institutional arrangements that lead to employment contracts that we have termed "strongly efficient." Strong efficiencyimplies that employment is set so as to equate the marginal revenue product of workers to their alternative wage. It follows that employment in such contracts fluctuates with the determinants of a worker's marginal revenue product and with the worker's alternative wage, but not with the observed contract wage. We have examined two kinds of evidence to test the strong efficiency hypothesis. Laboratory experiments by Siegel et al. indicate that this hypothesis is strongly confirmed when the bargaining parties are required to agree on price and quantity simultaneously and is strongly rejected when the parties are required to bargain by a system of price leadership. In our field data on the printing trades, we find no convincing evidence of strong efficiency. We have also examined the evidence in support of what we have called the "weak efficiency hypothesis." According to this hypothesis, both the contract wage and the alternative wage determine employment. We have found only mixed support for this hypothesis because our measures of the alternative wage available to workers are frequently positively related to employment, precisely the contrary to the hypothesized direction of this effect in a weakly efficient contract.