Implicit contract theory
Encyclopedia
In economics, implicit contracts refer to voluntary and self-enforcing long term agreements made between two parties regarding the future exchange of goods or services. Implicit contracts theory was first developed to explain why there are quantity adjustments (layoffs) instead of price adjustments (falling wages) in the labor market during recessions.
In the context of the labor market, an implicit contract
is an employment agreement between an employer and an employee that specifies how much labor is supplied by the worker and how much wage is paid by the employer under different circumstances in the future. An implicit contract can be an explicitly written document or a tacit agreement (some people call the former an "explicit contract"). The contract is self-enforcing, meaning that neither of the two parties would be willing to breach
the implicit contract in absence of any external enforcement since both parties would be worse off otherwise.
The interpersonal negotiation and agreement in implicit contracts contrasts with the impersonal and unilateral decision making in a decentralized competitive markets. As Arthur Melvin Okun
puts it best: a contract market is like an "invisible handshake" rather than the invisible hand
.
equals total labor demand
. If workers supply more labor than firms demand, then the wage level should fall so that workers will work fewer hours and firms would demand more labor. Hence, when firms reduce labor demand during a recession, we should expect to see a fall in wages as well. However, in reality, firms layoff redundant workers while keeping the wage unchanged for the rest of the workforce, and the wage compensation fluctuates considerably less than employment does in a typical business cycle
. Therefore, the law of supply and demand
is insufficient to explain patterns in wages and employment.
in 1974 and 1975. In their models, the firm and its workers are not simply the buyer and sellers of labor service in a sequential spot market
; Instead, the employer and workers engage in a long term relationship that enables risk sharing. The key insight (or assumption) is that the employers are risk neutral
while the workers are risk averse. This difference in attitude towards risk enables both parties to benefit from a long term employment relationship. Under the implicit contract, a worker is able to reduce the fluctuation in his labor income and the employer is able to increase his average profit. Hence, both parties are better off than being in the spot market. Therefore, the implicit contract between a worker and an employer is like insurance
used to hedge
the risk in the spot labor market. Layoffs act as the insurance premium that workers pay for the stability in the insurance
schedule in the long run.
shares some of the "imperfections" of the labor market discussed above: long term relationships between banks and borrowers act like the long term employment relationship between an employer and his workers. Like layoffs in the labor market, there is credit rationing
in the financial market. Also, a typical loan contract is just like an employment contract illustrated in the model above:
the loan repayment is fixed in all states of nature as long as the borrower is solvent. Hence naturally, economists tried to extend and apply the implicit contract theory to explain these phenomena in the capital market.
The earliest studies to employ implicit contracts models in capital markets see the existence of credit rationing as part of an equilibrium
risk-sharing arrangement between a bank and its customer: the bank is risk neutral, and the borrower is risk averse, hence they gain from a long term relationship via shifting the interest rate risk
from the borrower to the bank. If loans are negotiated in the spot market, then the borrower would be exposed to fluctuations in the spot market interest rates on her loan. Instead, if the borrower engages in an implicit contract with a bank, the bank can shield the borrower from fluctuations in the spot market by offering her a constant rate on the loan and in return for a higher average interest rate in the long run. However, if every bank charges a higher interest rate than the average rate in the spot market, then there would be credit rationing. This approach hinges on the assumption that agents (bank and the borrower) have different attitudes towards risk. However, more recent studies of capital markets do not rely on different attitudes towards risk, instead they focus on asymmetric information and the default risk in the capital markets. Also, implicit contracts have been playing an important role in explaining credit rationing under asymmetric information.
s".
as the main consequence of the information imperfection between lender and the borrower; however, there is also the problem of moral hazard
. In general there are two moral hazard problems related to the capital market. First, borrowers could lie about their financial situation and not repay their debts in full. If the lender could not check whether the borrower is lying, then there might not be any lending in the market at all, especially when the debt is unsecured. Second, when a borrower, for example, a firm makes a bad decision that leads to its bankruptcy, it does not bear the full consequence of her mistake since part of the cost will be born by the bank that helps finance the project. Therefore the firm is likely to make riskier decisions when the investment is financed by a bank than when the investment is financed out of the firm's own pocket. Economists show that these problems could be solved by an implicit contract in which the borrower has to pay some costs when she defaults on the debt. The borrower's cost of default can be the expense of hiring lawyers and accountants to persuade the lender of her financial distress, exclusion from capital market and future borrowing, or economic sanctions
if the borrower is a country. However, since some of these costs will reduce the amount collectible to the lender in the bankruptcy, the expected rate of return is lower than if there were no moral hazard problems. Therefore, the investment level would also be lower, causing credit rationing in the size of loans.
In the context of the labor market, an implicit contract
Contract
A contract is an agreement entered into by two parties or more with the intention of creating a legal obligation, which may have elements in writing. Contracts can be made orally. The remedy for breach of contract can be "damages" or compensation of money. In equity, the remedy can be specific...
is an employment agreement between an employer and an employee that specifies how much labor is supplied by the worker and how much wage is paid by the employer under different circumstances in the future. An implicit contract can be an explicitly written document or a tacit agreement (some people call the former an "explicit contract"). The contract is self-enforcing, meaning that neither of the two parties would be willing to breach
Breach
-In law:* Breach of confidence, a common law tort that protects private information that is conveyed in confidence* Breach of contract, a situation in which a binding agreement is not honored by one or more of the parties to the contract...
the implicit contract in absence of any external enforcement since both parties would be worse off otherwise.
The interpersonal negotiation and agreement in implicit contracts contrasts with the impersonal and unilateral decision making in a decentralized competitive markets. As Arthur Melvin Okun
Arthur Melvin Okun
Arthur Melvin "Art" Okun was an American economist. He served as the chairman of the Council of Economic Advisers between 1968 and 1969...
puts it best: a contract market is like an "invisible handshake" rather than the invisible hand
Invisible hand
In economics, invisible hand or invisible hand of the market is the term economists use to describe the self-regulating nature of the marketplace. This is a metaphor first coined by the economist Adam Smith...
.
Layoff puzzle
In traditional economic theory, a worker takes his wage as given and decides how many hours he works. The firm also takes the wage as given and decides how much labor to buy. Then wage is determined in the market to ensure total labor supplySupply (economics)
In economics, supply is the amount of some product producers are willing and able to sell at a given price all other factors being held constant. Usually, supply is plotted as a supply curve showing the relationship of price to the amount of product businesses are willing to sell.In economics the...
equals total labor demand
Demand
- Economics :*Demand , the desire to own something and the ability to pay for it*Demand curve, a graphic representation of a demand schedule*Demand deposit, the money in checking accounts...
. If workers supply more labor than firms demand, then the wage level should fall so that workers will work fewer hours and firms would demand more labor. Hence, when firms reduce labor demand during a recession, we should expect to see a fall in wages as well. However, in reality, firms layoff redundant workers while keeping the wage unchanged for the rest of the workforce, and the wage compensation fluctuates considerably less than employment does in a typical business cycle
Business cycle
The term business cycle refers to economy-wide fluctuations in production or economic activity over several months or years...
. Therefore, the law of supply and demand
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...
is insufficient to explain patterns in wages and employment.
Implicit contracts as insurance
In an effort to explain the layoff puzzle, models with implicit contracts were independently developed by Martin Baily, Donald Gordon, and Costas AzariadisCostas Azariadis
Constantine Christos "Costas" Azariadis, is a macroeconomist who was born February 17, 1943 in Athens, Greece. He has worked on diverse topics, such as labor markets, business cycles, and economic growth and development...
in 1974 and 1975. In their models, the firm and its workers are not simply the buyer and sellers of labor service in a sequential spot market
Spot market
The spot market or cash market is a public financial market, in which financial instruments or commodities are traded for immediate delivery. It contrasts with a futures market in which delivery is due at a later date...
; Instead, the employer and workers engage in a long term relationship that enables risk sharing. The key insight (or assumption) is that the employers are risk neutral
Risk neutral
In economics and finance, risk neutral behavior is between risk aversion and risk seeking. If offered either €50 or a 50% chance of each of €100 and nothing, a risk neutral person would have no preference between the two options...
while the workers are risk averse. This difference in attitude towards risk enables both parties to benefit from a long term employment relationship. Under the implicit contract, a worker is able to reduce the fluctuation in his labor income and the employer is able to increase his average profit. Hence, both parties are better off than being in the spot market. Therefore, the implicit contract between a worker and an employer is like insurance
Insurance
In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...
used to hedge
Hedge
Hedge may refer to:* Hedge or hedgerow, line of closely spaced shrubs planted to act as a barrier* Hedge , investment made to limit loss* Hedge , intentionally non-committal or ambiguous sentence fragments-See also:...
the risk in the spot labor market. Layoffs act as the insurance premium that workers pay for the stability in the insurance
Insurance
In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...
schedule in the long run.
Decline of implicit contract theory in labor economics
Despite the popularity of implicit contract theory in the 1980s, applications of the implicit contracts theory in labor economics has been in decline since 1990s. The theory has been replaced by search and matching theory to explain labor market imperfections.Implicit contracts in capital market
Capital marketCapital market
A capital market is a market for securities , where business enterprises and governments can raise long-term funds. It is defined as a market in which money is provided for periods longer than a year, as the raising of short-term funds takes place on other markets...
shares some of the "imperfections" of the labor market discussed above: long term relationships between banks and borrowers act like the long term employment relationship between an employer and his workers. Like layoffs in the labor market, there is credit rationing
Credit rationing
Credit rationing refers to the situation where lenders limit the supply of additional credit to borrowers who demand funds, even if the latter are willing to pay higher interest rates. It is an example of market imperfection, or market failure, as the price mechanism fails to bring about...
in the financial market. Also, a typical loan contract is just like an employment contract illustrated in the model above:
the loan repayment is fixed in all states of nature as long as the borrower is solvent. Hence naturally, economists tried to extend and apply the implicit contract theory to explain these phenomena in the capital market.
The earliest studies to employ implicit contracts models in capital markets see the existence of credit rationing as part of an equilibrium
Equilibrium
Equilibrium is the condition of a system in which competing influences are balanced. The word may refer to:-Biology:* Equilibrioception, the sense of a balance present in human beings and other animals...
risk-sharing arrangement between a bank and its customer: the bank is risk neutral, and the borrower is risk averse, hence they gain from a long term relationship via shifting the interest rate risk
Interest rate risk
Interest rate risk is the risk borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa...
from the borrower to the bank. If loans are negotiated in the spot market, then the borrower would be exposed to fluctuations in the spot market interest rates on her loan. Instead, if the borrower engages in an implicit contract with a bank, the bank can shield the borrower from fluctuations in the spot market by offering her a constant rate on the loan and in return for a higher average interest rate in the long run. However, if every bank charges a higher interest rate than the average rate in the spot market, then there would be credit rationing. This approach hinges on the assumption that agents (bank and the borrower) have different attitudes towards risk. However, more recent studies of capital markets do not rely on different attitudes towards risk, instead they focus on asymmetric information and the default risk in the capital markets. Also, implicit contracts have been playing an important role in explaining credit rationing under asymmetric information.
Implicit contracts under adverse selection
Some argue that the creditor-debtor long term relationship arises from the valuable "inside information" revealed via repeated bank-firm interactions. This "inside information" reduces the information asymmetries and identifies the most productive firms (those with lower default risks). Hence the bank is able to better allocate financial resources and ensure that more capital goes to higher quality firms. This view is usually referred to as relationship banking, and it has attracted significant research interests in the field of finance. The empirical evidence for relationship banking is mixed. A recent study shows "that repeated borrowing from the same lender translates into a 10–17 basis points lowering of loan spreads and that relationships are especially valuable when borrower transparency is low" by using data from the US, However, using survey data from Japan, another recent study finds that the long term relationship between borrower and lender "in some cases increased cost, from stronger relationships for opaque borrowers and for borrowers who get funding from small banks. These latter findings suggest the possibility that relationship borrowers may suffer from capture effectCapture effect
In telecommunication, the capture effect, or FM capture effect, is a phenomenon associated with FM reception in which only the stronger of two signals at, or near, the same frequency will be demodulated....
s".
Implicit contracts under moral hazard
The relationship banking approach focuses on adverse selectionAdverse selection
Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, statistics, and risk management. It refers to a market process in which "bad" results occur when buyers and sellers have asymmetric information : the "bad" products or services are more likely to be...
as the main consequence of the information imperfection between lender and the borrower; however, there is also the problem of moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...
. In general there are two moral hazard problems related to the capital market. First, borrowers could lie about their financial situation and not repay their debts in full. If the lender could not check whether the borrower is lying, then there might not be any lending in the market at all, especially when the debt is unsecured. Second, when a borrower, for example, a firm makes a bad decision that leads to its bankruptcy, it does not bear the full consequence of her mistake since part of the cost will be born by the bank that helps finance the project. Therefore the firm is likely to make riskier decisions when the investment is financed by a bank than when the investment is financed out of the firm's own pocket. Economists show that these problems could be solved by an implicit contract in which the borrower has to pay some costs when she defaults on the debt. The borrower's cost of default can be the expense of hiring lawyers and accountants to persuade the lender of her financial distress, exclusion from capital market and future borrowing, or economic sanctions
Economic sanctions
Economic sanctions are domestic penalties applied by one country on another for a variety of reasons. Economic sanctions include, but are not limited to, tariffs, trade barriers, import duties, and import or export quotas...
if the borrower is a country. However, since some of these costs will reduce the amount collectible to the lender in the bankruptcy, the expected rate of return is lower than if there were no moral hazard problems. Therefore, the investment level would also be lower, causing credit rationing in the size of loans.