Wage rigidity, implicit contracts, and economic efficiency : are market wages too flexible?

Abstract

The analysis of implicit contracts between risk-averse workers and risk-neutral firms must recognize that: (i) the contract is implicit, not explicit; (ii) it may only be conditioned on observable variables; and (iii) there are limits to contract complexity. If contracts are perfectly flexible than neither the constraint of enforceability nor observability result in unemployment. However, even with perfect enforceability and flexibility, limitations on contract flexibility may generate unemployment. Finally, even with flexible enforceable contracts and no unemployment the market equilibrium is inefficient. We construct some simple general equilibrium models and explore the consequences of restrictions of the set of feasible contracts, at the same time commenting on the present state of implicit contract theory.