Braz Ministerio de Camargo, FGV – Brasil

Paper: Labor Demand in Relational Contracts

Abstract: We study relational contracts when a firm not only cannot commit to motivating workforce effort, but also cannot commit to workforce size. We analyze both bilateral and multilateral contracts. The interaction between effort incentives and labor demand yields novel and surprising results. Whereas effort and production are distorted downward relative to the first best, lack of commitment can lead to an increase in workforce size when effort and workforce size are strategic substitutes. We extend our model to allow replacement costs and show that bilateral contracts perform poorly compared to multilateral contracts when those costs are low. We also extend our model to consider the case in which workers leave the firm due to exogenous reasons. In this case, rewarding loyal workers emerges as an optimal policy. When the firm must treat all workers symmetrically, an optimal multilateral contract may involve the firm shutting down operations if too many employees leave. We also use our model to analyze other labor market phenomena such as heterogeneous labor forces and productivity shocks, whether observable or not.