On Implicit Contracts and Involuntary Unemployment

We show that a firm can increase expected profits by undertaking the additional expense of paying unemployment compensation to the workers it lays off, if they are risk averse. When this argument is applied to the implicit contract models it makes the involuntary unemployment derived there disappear, where by involuntary unemployment we mean a situation in which one worker has a job at a wage w and another worker who is known to be productively identical and willing to take on the job at a lower wage h cannot find a job.

We introduce into our model asymmetric information between sectors of the economy. Each agent knows the state of his own firm but not that of others. We suppose also that workers have specific skills which are conformable to some, but not all, firms in the economy. In this model we reestablish the phenomenon of involuntary unemployment in a general implicit contracts equilibrium in which the proportion of layoffs, the “stabilized” wage, and the severance payments are endogenously determined. Moreover, we show that the presence of involuntary unemployment is a signal that there is too little output in the most productive sectors of the economy, thereby restoring the link between underproduction and involuntary unemployment missing in the implicit contracts literature. Finally we ask how large should be the severance payment a profit maximizing firm gives to each worker from a branch it shuts down, when there is uncertainty about what jobs those workers will find. We prove that the rational expected-profit-maximizing firm will offer a contract which provides severance compensation so generous that on average the workers dismissed by the closing of a plant can expect to be better off than if they had been retained, in the case that they have decreasing absolute risk aversion.