American Economic Association

Equilibrium Unemployment as a Worker Discipline Device Author(s): Carl Shapiro and Joseph E. Stiglitz Source: The American Economic Review, Vol. 74, No. 3 (Jun., 1984), pp. 433-444 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/1804018 . Accessed: 27/09/2013 11:54
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Equilibrium as a Worker Unemployment DisciplineDevice

By CARL
SHAPIRO AND JOSEPH E. STIGLITZ*

Involuntary unemployment appearsto be a persistent feature of manymodemlabor markets. The presence of such unemployment thequestion ofwhy raises wages do not fallto clearlabormarkets. In thispaperwe showhowtheinformation structure of employer-employee in particular relationships, theinability of employers to costlessly observe workers' on-the-job can explain effort, involuntary unemployment' as an equilibrium phenomenon. Indeed, we showthat imperfect monitoring necessitates unemployinequilibrium. ment The intuition our result is simple. behind Under the conventional competitive parainwhich all workers digm, receive themarket wage and thereis no unemployment, the worstthat can happen to a worker who shirks on thejob is that he is fired. Sincehe canimmediately be rehired, hepays however, no penalty hismisdemeanor. for With imperfect and fullemployment, theremonitoring fore, workers willchooseto shirk. To induce itsworkers nottoshirk, thefirm topaymore than attempts the"going wage"; if a worker is caught and is then, shirking he willpay a penalty. If it pays one fired, firm to raiseitswage, itwillpayall however, firms toraisetheir wages. When all raise they their theincentive notto shirk wages, again Butas all firms raisetheir disappears. wages, for their demand labordecreases, and unemWith even ployment results. unemployment, ifall firms a worker has paythesamewages, an incentive notto shirk. For,if he is fired,

tively, Princeton Princeton, NJ 08540.We University, thank GeneGrossman, Ed Lazear, Peter Diamond, Steve Salop,and MikeVeallfor helpful comments. Financial from the National is appresupport Science Foundation ciated. 'By involuntary unemployment we meana situation where an unemployed worker is willing to work for less skilled thanthewagereceived by an equally employed yet nojob offers areforthcoming. worker,

obtain will not immediately an individual unemployment job. The equilibrium another largethatit pays rate mustbe sufficiently thanto taketherisk rather to work workers shirking. caught ofbeing a worker offiring thethreat The idea that is notnovel.Guilof discipline is a method a staticmodel lermoCalvo (1981) studied unemployment.2 equilibrium involves which No previousstudieshave treatedgeneral however, with dynamics, market equilibrium of such properties or studiedthe welfare One keycontribuequilibria. unemployment tion of thispaper is thatthe punishment as is endogenous, fired being with associated rateof unemon theequilibrium it depends Our analysisthus goes beyond ployment. within and incentives of information studies Alchianand (such as Armen organizations 1972,and themorerecent HaroldDemsetz, relaon worker-firm literature and growing to inproblem) tionsas a principal-agent in conditions quire about the equilibrium features. these informational with markets tooursis Steven in spirit Thepaperclosest turnover firms reduce Salop (1979)in which thesavings raisewages;here costswhen they costs wagesare on monitoring higher from from (or, at the same levelof monitoring, As effort). due to increased output increased in this theunemployment in theSaloppaper, and not involuntary, paper is definitely searchtheory type(Peter of the standard have Workers 1981,forexample). Diamond, information aboutall job opportuniperfect workers and unemployed tiesin ourmodel, at wageslessthanthe to work strictly prefer WilsonSchool of Publicand Interna- prevailing *Woodrow thanto rewage (rather market tionalAffairs, and Department of Economics, respec- mainunemployed); areno vacancies. there
a variety of 2In his 1979 paper,Calvo surveyed firm hishierarchical including ofunemployment, models 1979).Thereare a Wellisz, Stanislaw model(also with work and between that differences ofimportant number ofthemonitoring this thespecification including paper, technology.

433

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434

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The theory we develophas severalim- other firms do. The dual rolewagesplayby portant implications. First,we show that allocating laborand providing incentives for unemployment benefits (and otherwelfare employee effort allows wage dispersion to benefits) theequilibrium increase unemploy- persist. mentrate,but fora reasonquitedifferent Although we havefocused ouranalysis on from that commonly putforth (i.e.,that indi- thelabormarket, it shouldbe clearthata vidualswill have insufficient incentives to similar to other analysis couldapply markets search for theexistence (forexample, jobs). In ourmodel, or credit product as markets) ofunemployment benefits reduces the"pen- well.Thispapercan be viewed as an analysis alty"associated with beingfired. Therefore, of a simplified general equilibrium modelof to induceworkers not to shirk, firms must an economy in whichthereare important Thesehigher payhigher wages. wages reduce principal-agent (incentive) problems, and in thedemand for labor. which the equilibriumentails quantity conSecond,the model explainswhy wages straints (job rationing). As in all suchprobin thefaceofaggregate adjustslowly shocks. lems, it is important to identify whatis obA decreasein the demandfor labor will servable, and,based on whatis observable, ultimately cause a lowerwageand a higher what are the set of feasiblecontractual In the transition, arrangements level of unemployment. between theparties to theconwill matchthe tract.Undercertain however, the wage decrease forincircumstances, in the unemployment growth pool, which stance,workers mightissue performance maybe a sluggish process. bondsand thismight alleviate theproblems Third,we show that the market equi- withwhich we are concerned in thispaper. is not, in general, In Section librium whichemerges III we discuss theroleof alternaParetooptimal, wherewe have takenex- tiveincentive devices. plicitly intoaccount thecostsassociated with In thehighly simplified model uponwhich in other in- we focushere,all workers Thereexist, monitoring. words, are identical, all terventions in themarket makeeveryone firms that are identical, in equilibrium, and thus, In particular, better off. we showthatthere all pay thesamewage.The assumption that are circumstances in whichwage subsidies all workers are the same is important, beare desirable. Thereare also circumstances cause it implies thatbeingfired no carries wherethe government in stigma shouldintervene knows (the nextpotential employer themarket in- that by supplying unemployment theworker is no more immoral than any evenifall firms surance, (rationally) do not. other infers for worker; he only that thefirm A (small)turnover tax is desirable, because which theworker worked musthavepaid a high turnover increasesthe flow of job wagesufficiently low that it paid theworker vacancies, and hence the flowout of the to shirk). We have made this assumption the threat of becausewe wished unemployment pool, making to construct thesimplest lesssevere. modelfocussing on incentive firing possible simply our theory in which Additionally, provides predic- effects, adverse selection considerations about the characteristics of labor tionsplayno role.In a sequel,we hope to whichcause the natural rate (i.e., explorethe important markets interactions between to be the two fundamental equilibrium level) of unemployment information problems ratesof laborturnover, ofadverse relatively high:high selection andmoral hazard.3 rates highmonitoring costs,highdiscount The assumption that all firms arethesame for for work- is notcritical workers, significant possibilities for ofequilibrium theexistence to unemployment. erstovary their effort orhigh costs Firm heterogeneity inputs, will, from however, employers (suchas broken machinery) lead to a wagedistribution. If the shirking. Finally, ourtheory shows howwagedistri3Otherstudies on quantity havefocused constraints in (rationing) can persist butions (foridentical workers) with adverse-selection problems. See Stiglitz equilibrium. Firmswhich find shirking par- (1976),CharlesWilson(1980),Andrew Weiss(1980), andWeiss(1981). willoffer ticularly costly higher wagesthan and Stiglitz

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VOL. 74 NO. 3

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435

incursas a firm damagethata particular up to not performing resultof a worker will have an the firm is larger, standard wage. a higher to pay theworker incentive ifthecostofmonitoring (detecting Similarly, will is large,thatfirm fora firm shirking) wage.Thus,eventhough also pay a higher fordifferworkers are all identical, workers willreceive wages.There different entfirms in fact, differthat, evidence is considerable wagesto workers entfirms do pay different (forexample, whoappearto be quitesimilar firmspay higher more capital intensive we develophere may wages).The theory of thisphepartof theexplanation provide nomenon. in In Section thebasicmodel I, wepresent Quit rates whichworkers are riskneutral. A are exogenous. intensities and monitoring equiof theunemployment analysis welfare II, we comIn Section is provided. librium of theanalysis to situament on extensions and quit monitoring intensities tionswhere are workers and where rates areendogenous, theroleof III compares Section riskaverse. devicewith as an incentive unemployment on the ofenforcing other discipline methods laborforce. I. TheBasic Model In this a simple model section weformulate role of unemcaptures theincentive which and above.Extensions as described ployment ofthis basicmodelareconsidmodifications sections. eredin subsequent
A. Workers

he is unemployed, e > O.' Whena worker of -w(and benefits receives unemployment e = 0). is in one oftwostates at any Each worker or unemployed. point in time: employed a that b perunittime Thereis a probability from hisjob due to worker willbe separated willbe taken as exogetc.,which relocation, causea worker separations enous.Exogenous pool. Workers to enterthe unemployment present discounted the expected maximize rater > O.' witha discount value of utility time. is setin continuous Themodel
B. TheEffort Decisionofa Worker

is theselecmake The only choice workers tion of an effort level,whichis a discrete If a worker performs choiceby assumption. forhisjob, at thecustomary levelof effort he receives a thatis, if he does not shirk, exoghisjob until wageof w and willretain If causea separation to occur. enousfactors he shirks, there is someprobability q (disthathe willbe perunittime, cussedbelow), he willbe If he is caught shirking caught.6 theunemployment to enter fired,7 and forced time ofacquirperunit pool.Theprobability pool ing a job whilein theunemployment rate,an (whichwe call thejob acquisition variable calculated below)deterendogenous of theunemploymines theexpected length ment spellhe mustface.Whileunemployed of compensation unemployment he receives
-w (also discussedbelow).
not would variable as a continuous 4Includingeffort results. thequalitative change lived, are infinitely individuals 5Thatis, we assume of r. They and have a purerateof timepreference maximize W= EJ u(w(t),e(t))exp(rt) dt,

number, N, of identical Thereare a fixed forth all of whomdislikeputting workers, butenjoy consuming goods.We write effort, an individual's instantaneous utility function w is thewagereceived and as U(w,e), where on the e is thelevelofeffort job. Forsimplicis function ity,we shall assumethe utility that we shallalso assume initially, separable; norare riskneutral. Withsuitable workers rewrite we can therefore utility malizations, we asas U = w - e. Again, for simplicity, minimal either workers canprovide sume that levelof effort positive (e = 0), or somefixed

can individuals that assumed we haveimplicitly where death an exponential norlend.Allowing borrow neither neither of themodel; thestructure notalter ratewould case. in therisk-neutral wouldborrowing laterit willbe 6For nowwe take q as exogenous; of a Poissondetection The assumption endogenous. of the otherassumptions like a number technology, thatthe is made to ensure in the analysis, employed structure. stationary model hasa simple in equilibrium. policy willbe firm's optimal 7This

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436

THE AMERICA N ECONOMIC RE VIE W

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The worker selects an effort levelto maximize his discounted utilitystream.This involves comparison oftheutility from shirking withthe utility fromnot shirking, to whichwe now turn. We define VE,as the of an employed expectedlifetime utility shirker, lifetime utility of VE as theexpected an employed nonshirker, and VuK as the expected lifetime utility of an unemployed individual. The fundamental assetequation fora shirker is given by
(l)

is a penalty there oftheNSC: unless plication everyone beingunemployed, with associated if an individual words, In other will shirk. after obtainemployment couldimmediately
= VEs,and the NSC could being fired, V"K

be satisfied. never implicanatural Equation(5) has several high pays a sufficiently tions.If the firm The willnot shirk. wage,thentheworkers
criticalwage, w',is higher

rVEs = W + ( b +

q)(V,,- VEs),

while for a nonshirker, it is (2)

rVEN= w-e

+ b(Vu-V)V

Each of these equations is of theform "interest rate times assetvalueequalsflow benefits(dividends) plus expected capitalgains (or losses)."8Equations (1) and (2) can be solved forVES and VEN:
(3) VES= w+(b+q)VJK

effort (e), therequired (a) thehigher utility associtheexpected (b) thehigher unemployed being atedwith (V,), of being (c) the lowerthe probability shirking (q), detected therateof interest (i.e., (d) thehigher is attached to the more weight therelatively (untilone is shirking gainsfrom short-run when incurred tothe losses compared caught) one is eventually caught), quitrateb theexogenous (e) thehigher (if one is goingto have to leave the firm on thefirm). as wellcheat onemight anyway, C. Employers

i =1,..., M. Thereare M identical firms, function Each firm has a production Qi = production aggregate an generating f(Li), (w-e)+bVU N= (4) (4) VE r+b i's function of Q = F(L).9 Here Li is firm labor force;we assumea worker effective The worker willchoosenotto shirk ifand contributes one unitof effective laborif he he contributes onlyif VEN VE.We call this theno-shirking does not shirk.Otherwise Therefor simplicity). is merely (this condition nothing (NSC), which,using (3) and (4), in offering can be written fore firms wagepackages, as compete workers to theconstraint thattheir subject We assume thatF'(N) choosenotto shirk. (5) w>rVu+(r+b+q)e/q=aW. > e, that is efficient. employment is,full Alternatively, theNSC also takestheform The monitoring technology (q) is exogethe basic imare choices by employers nous. Monitoring q(VEs- V")2 e. This highlights We assume in thefollowing section. analyzed
8A derivation follows: taking Vuas given andlooking at a short time interval [0,t] wehave

+ (1- rt)[bt, + (1- bt)VE], VE= wt

interval [0, t] and since e

9That is, F(L) maxEf (Li)

(Li I

the since there is probability btofleaving job during the have

1- rt.Solvingfor VE, we

VE=

wt+ (1- rt) btVu ] [1 - (1-rt)(l- bt)] .

as t- 0 gives(1). Equation Takinglimits (2) can be derived similarly.

thatin market suchthatELi = L. This assumes equilibrium, laboris efficiently as it willbe in the allocated, of this section. The modifications basicmodel required firms formore different facediffergeneral cases,when ent critical no-shirking wages,wv,or have different arestraightforward. technologies,

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VOL. 74 NO.3

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437

thatotherfactors (forexample, exogenous noise or the absenceof employee specific ofeffort output measures) prevent monitoring via observing output. A firm's wagepackage consists of a wage, w, and a level of unemployment benefits, Eachfirm finds itoptimal -w.10 tofire shirkers, since the only otherpunishment, a wage reduction, would simply inducethe disciplined worker toshirk again. It is notdifficult to establish all firms that aloffer thesmallest benefits unemployment lowed(say,by law).11 This follows directly from theNSC, equation (5). An individual firm has no incentive to set Tvany higher An increase in -wraisesVu thannecessary. w to meetthe and hencerequires a higher in -w NSC. Therefore, increases costthefirm both directly (higher unemployment benefits) and indirectly (higher wages).Sincethefirm has no difficulty labor (in equiattracting librium), itsets-w as small as possible. Hence we can interpret as the -win whatfollows minimum is offered conlegal level,which sistently byall firms. offered theminimum allowable Having w, an individual firm to pays wagessufficient

Equilibrium D. Market

of the We nowturn to thedetermination levels. Let wageandemployment equilibrium which the factors heuristically indicate us first wagelevel. theequilibrium determine willvalue workers high, If wagesare very wages (a) thehigh jobs for tworeasons: their low and (b) thecorrespondingly themselves, for (due to lowdemand levelofemployment longspells implies which wages) laborat high one's in theevent oflosing ofunemployment willfind employers job. In sucha situation tempting they can reduce wages without to shirk. workers if the wage is quite low, Conversely, to shirkfor two will be tempted workers working is that (a) lowwagesimply reasons: to unemployment, preferred onlymoderately levels (at lowwages and(b) high employment thereis a largedemandforlabor) imply will spellsdue to beingfired unemployment willraise firms In sucha situation be brief. theNSC. wagesto satisfy their taking occurs when eachfirm, Equilibrium levels at thewagesand employment as given thegoing tooffer finds itoptimal firms, other wage.The key thana different wagerather induce employee effort, that is, w = iw to individual which determines market variable meettheNSC. The firm's labordemand is ofan firm is Vu, theexpected utility behavior givenby equating themarginal product of worker. We turnnow to the labor to the cost of hiring an additional unemployed oftheequilibrium This cost consists calculation of wagesand employee. Vu.13 = 0,12 to(1) The assetequation forVu, analogous future For TV unemployment benefits. and (2), is given by thelabordemand is given simply byf'(Li) = w, with aggregate labordemand of F'(L) (6) rVu=W+a(VE-VV), = W. a is the rateand VE is job acquisition where worker theexpected of an employed utility We can (whichequals VEjin equilibrium). forVE now solve(4) and (6) simultaneously and Vuto yield

l'More complex employment contracts, for example, in Section wages rising with seniority, arediscussed III. of stationarity and identical With our assumptions workers, employers cannot improve on thesimple employment provisions considered here. rVE= (w e)(a+br)+b (7) "We are implicitly assuming thatthe firm cannot whoquit. Thisis so because the w only offer toworkers + + r) firm can always fire a worker whowishes to quit, andit = (w e)a (8) +r a + bi(b rVu would be optimal for thefirm to do so. is the 12For w> 0 theexpected cost of a worker wagecostfortheexpected employment period of 1/b, followed by w fortheexpected periodof unemploy13Wehavealready shown that all firms offer thesame ment, 1/a. Thisgenerates labordemand given by employment benefits iw, so Vuis indeed a single number, i.e.,an unemployed person's utility is independent ofhis = w +.b( frLi )/ r+ . previous employer.

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438

THE AMERICAN ECONOMIC REVIEW

WAGESA

JUNE 1984

into the NSC (5) yieldsthe aggregate NSC (9) w>-w+e+e(a+b+r)/q.

Substituting theexpression forVu(i.e.,(8))

REGION NOSHIRKING

Noticethat thecritical wagefornonshirking is greater: (a) thesmaller thedetection prob(br q ~~~~~NSC (II1) eSC ability q; (b) thelarger theeffort e; (c) the Wv+e+qbr w+e e higher the quit rate b; (d) the higher the interest rater; (e) thehigher theunemployEMPLOYMENT N L mentbenefit (Tv); and (f) the higher the flows outofunemployment a. FIGURE 1. THE AGGREGATENO-SHIRKING CONSTRAINT We commented above on the first four properties; thelasttwoarealsounsuiprising. If the unemployment benefit this, workers willchooseto Knowing is high,the hired. expected ofan unemployed utility individual shirk. is high, and therefore thepunishment associThe equilibrium wage and employment ated withbeingunemployed Each (small) is low. To in- levelare now easyto identify. duceindividuals notto shirk, a higher job acquisition takingthe aggregate wage firm, mustbe paid. If a is the probability at finds thatit mustoffer of rate a as given, a job perunitof time, obtaining 1/a is the least the wage w'. The firm'sdemand for ofbeing are expected howmany workers duration laborthen determines The unemployed. longer theduration, where thegreater occurs at thewage.Equilibrium thepunish- hired with ment associated theaggregate demand for laborintersects the being and unemployed, hence thesmaller thewagethat = 0, equilibrium is required to ocNSC. For -w aggregate induce nonshirking. curswhen The rate a itself can be related to more fundamental of themodel, in a parameters F'(L) = e + (e/q)(bN/(N - L)+ r). In steady statethe steady-state equilibrium. flow into theunemployment poolis bL where in Figure 2.14It The equilibrium is depicted L is aggregate The flow out is employment. which theforces is important to understand a(N - L) (per unit time) where N is the From the cause E to be an equilibrium. totallaborsupply. Thesemustbe equal,so firm's pointof view,thereis no pointin bL = a(N- L), or are providing raising wages since workers effort and thefirm can get all thelaborit a = bL/(N- L). (10) on theother wantsat w*. Lowering wages, shirking and be a losing for a into (9), the aggregate hand,wouldinduce Substituting
NSC, we have idea."5 is involuntary: those withoutjobs ployment (( bNL) +r)

Fromthe worker's pointof view,unem-

(11) w?e+ v+
=e

+ w + (e/q)(b/u + r) -w,

but to work at w*or lower, wouldbe happy cannot makea credible notto shirk promise at suchwages.

where u = (N - L)/N, the unemployment

theaggregate rate.Thisconstraint, NSC, is in Figure1. It is immediately evigraphed

dent that no shirking is inconsistent with full If L = N, a = + x, so any employment.

worker would immediately be reshirking

-w =0 when is F'(L) only '4Aggregate labordemand (see fn.12). is zero whenan 15Wehave assumedthatoutput but we need only assumethata shirks, individual shirking low thathiring is sufficiently output shirker's is unprofitable. workers

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VOL. 74 NO. 3

SHAPIRO AND STIGLITZ: EQUILIBRIUM

AGGREGATE

UNEMPLOYMENT
NSC'
/

439
NSC1

LABOR DEMAND

AGGREGATE

WAGES w

ro/

ww

W~~~~~~~~~~~~~~~~~
z

I
I

) ~~~~~F'(L

F'(L)

wv+e ___ __ ___ __

l
___ _ _

- L

EMPLOYMENT

'__________________'-

L'

EMPLOYMENT

FIGURE

2. EQUILIBRIUM UNEMPLOYMENT

FIGURE 3. COMPARATIVE STATICS Note:A decrease in themonitoring intensity q, or an in thequitrateb, leads to higher increase wagesand more unemployment

Noticethatthetype of unemployment we havecharacterized here is very different from search unemployment. Here, all workers and all firms areidentical. is perfect There informationabout job availability. There is a different information firms problem: are assumed in ourview)notto (quitereasonably, be able to monitor the activities of their employees and perfectly. costlessly E. Simple Statics Comparative The effect of changing various parameters oftheproblem be determined. mayeasily As notedabove,increasing thequit rate b, or the monitoring decreasing intensity q, decreases incentives to exert effort. Therefore, these an increase in thewage changes require necessary (at each levelof employment) to induce individuals to work, that is,they shift theNSC curve upwards (see Figure3). On theother leavethedemand curve hand,they forlabor unchanged, and hence the equilibrium levelofunemployment and theequilibrium in wagearebothincreased. Increases benefits have the same imunemployment butthey pacton theNSC curve, also reduce labordemand as workers becomemoreexso they pensive, causeunemployment to rise tworeasons. for Inward shifts in thelabordemand schedule create moreunemployment. Due to the NSC, wages cannotfall enoughto comfor thedecreased labordemand. pensate The transition to thehigher unemployment equilibrium will not be immediate: wage decreases firms willonlybecome byindividual

attractive as theunemployment pool grows. This provides an explanation of wage sluggishness.

F. Welfare Analysis

In thissection we study thewelfare properties of theunemployment equilibrium. We demonstrate thatthe equilibrium is not in generalParetooptimal, when information costsareexplicitly accounted for. We beginwith thecase where theowners of thefirms are thesameindividuals as the workers, and ownership is equallydistributedamong N workers. Thecentral planning problem is to maximize theexpected utility of the representative worker subjectto the NSC and theresource constraint:
(12)
w,w,L

max (w-e)L

+ w(N-L)

subjectto w > e + w+ (e/q)((bN /(N-L)) + r) (NSC)

subjectto wL + w(N- L) < F(L)

(Feasibility) to w> O. subject

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440

THE AMERICAN ECONOMIC REVIEW

INDIFFERENCE CURVES WAGES w w=APL wAPL

JUNE 1984
NSC

Sinceworkers arerisk it is easyto neutral check'6thattheoptimum involves -w at the minimum allowable level, which is assumed to be 0. The reasonis thatincreases in -w theNSC, so all payments tighten should be madein theform of w rather w.
= 0, theproblemsimplifies Setting-w to max(w-e)L
w, L

F(L)/L
L+e

F'L)

(12')

subjectto w > e + (e/q)((bN/(N-L)) and wL<F(L).

+ r);

EMPLOYMENT

FIGURE 4. SOCIAL OPTIMUM AT A

The set of pointswhichsatisfy the conis shaded in Figure4. Iso-utility straints curves arerectangular hyperboles. So longas F'(L) > e, these are steeper thantheaverage productlocus, so the optimum occursat theNSC intersects pointA where thecurve w = F(L)/L, that is, where wagesequal the of labor. In contrast, averageproduct the market occursat E wherethe equilibrium marginal product of laborcurve, w= F'(L), intersects theNSC (Figure 2). Observe that in the case of constant returns to scale,

thatv > 0, orequivalently requires employed The be nonnegative.17 taxes after that profits awayall bytaxing can be achieved optimum of T, a wage subsidy and financing profits
shownin Figure4. The "natural" unemployrateis toohigh. ment

and the In the case wherethe workers thetaxpolicy individuals, owners aredistinct inabove would reduceprofits, described levemployment and increase creasewages, output aggregate els.While it wouldincrease would sucha taxpolicy costs), (netof effort since a Paretoimprovement, F'(L)L = F(L), so the equilibrium not constitute is optitheequimal. wouldfall.For thisreason, profits in thiscase, even is Paretooptimal Wagesshouldbe subsidized, usingwhat- librium net national ever(pure)profits can be taxedaway.An thoughit fails to maximize We thushave the unusualresult equivalent product. wayto viewthesocialoptimum is oftheequilibrium a tax on unemployment optimality to reduceshirking that thePareto The ofwealth. incentives; thewealth constraint on theunuponthedistribution depends and efficiency between separation standard overto does not carry incomedistribution thismodel. 16Formally, thattheequiIt shouldnotbe surprising Y2= (w- e)L+ -w(N- L) is in general librium levelof unemployment too employ to tends firm Each inefficient. - (e/q)(bN/(N - 1)+ r)] + A[ w - e - -w costof fewworkers, sinceit seestheprivate worker as w, whilethesocial an additional + It[F(L)wL -vw(N - L)]. is lower. On theother costis onlye, which it worker, hires one more hand,whena firm with of w and -w Differentiating respect yields has on oftheeffect this failsto takeaccount and=O if w>O. Y,=L+A-iL?0 the size of the unemployVu (by reducing externality a negative pool).Thiseffect, ment and=O if -w>O. .-=(N-L)-A-[L(N-L)?O its as itraises on others byone firm imposed
A = 0. Therefore, since A > 0, t > 1. But then 2'w = (N - L)(1- g)- A < 0. This impliesthat W= 0.

Weknow w> O bytheNSC, so2' =O, i.e.,L(1- p)+

usingthe -w 2 0 can be rewritten, 17Theconstraint as F(L)- wL 0 O,i.e.,v ? 0. constraint, resource

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VOL. 74 NO. 3

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levelof employment, tendsto lead to overB. RiskAversion In thesimple modelpresented employment. and the theoptimum so far, theformer effect risk neutrality, dominates, and the With is too high. marketboth involve w = 0. Clearly w = 0 natural levelof unemployment Thiswillnotbe true in more risk general are highly models, cannot ifworkers be optimal however, as we shallseebelow. their jobs from and maybe separated averse alreasons.Yet the market forexogenous = 0 (or thelegal minimum). ways providesiwv II. Extensions = 0 carries overto The proofabove thatwP In this section we describe howtheresults thecase ofrisk-averse workers. involvesunemployorextended When equilibrium when derived abovearemodified attracting we relaxsome of the simplifying assump- ment,firms have no difficulty w= 0, sincew> 0 and henceoffer in tum: workers tions.We discussthree extensions riskaversion, of beingfired. and merely reducesthe penalty endogenous monitoring, = 0, thisargument offer When otherfirms of wP tumover. Detailed derivations endogenous workers in our is only strengthened: unemployed theclaimsmadebeloware available that earlier It is striking working paper. are eveneasierto attract. benno unemployment provides themarket risk averse. A. Endogenous Monitoring when workers arehighly efits even involves w> 0 if thesocialoptimum Clearly Thismayproenough. When is great employees can select themonitoring riskaversion minimum can trade formandatory intensity q, they off stricter moni- videa justification toring (at a cost)with higher wagesas meth- benefit levels. ods of worker In general, discipline. firms' intensities will not be optimal, Turnover C. Endogenous monitoring due to the extemalities between firms depackage In general employment scribed above.In general, itis notpossible a firm's to rateitexperiences theturnover willinfluence ascertain whether theequilibrium entails too rate ortoolittle itsemployees. Sincethetumover much employment. In thecaseof among out of theunemb affects therateof hiring constantretumsto scale (F(L) = L), howother it affects pool,and henceVu, ever(which led to efficiency with exogenous ployment ofthis Because no-shirking constraints. thecompetitive in- firms' monitoring), equilibrium firms' choices of employment volvestoo muchmonitoring and too much externality, This willnotin general be optimal. packages employment. exterto search is similar ofextemality The result is not as unintuitive as it first type one searcher's in which, forexample, seems:each firm thattheonlyin- nalities believes or strument forreducing dependson thenumber at itscontrol utility shirking expected In in themarket. is to increase There remaining monitoring. is,however, mixofsearchers which discourage a secondinstrument: model, policies by reducing employ- thecurrent as theymake are attractive notto shirk. This labor tumover workers areinduced ment, to shirkers. more on monitor- unemployment costly enables to saveresources society These gains more than ing (supervision). offset thelossfrom thereduced the Methods for employment. III. Alternative It is straightforward to seehowthis ofDiscipline policy Enforcement Iffirms canbe induced maybe implemented. mechto reducetheir will be a particular welfare monitoring, Thispaper hasexplored inof discipline: increased. Hencea tax on monitoring, with anismfortheenforcement theproceeds arefired, whoaredetected distributed, say,as a lumpsum dividuals shirking transfer to firms, willleave theno-shirking and in equilibrium the level of unemploythis threat serves un- ment is sufficiently that constraint large constraint/national-resource The to shirking. butwillreduce deterrent as an effective affected, monitoring.

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are question naturally ariseswhether there disaltemative, lesscostly, or more effective cipline mechanisms.
A. Performance Bonds

disThe mostdirect mechanism by which is through the be enforced ciplinemight of performance bonds. posting by workers the worker would Underthisarrangement him forfeit the bond if the firm detected is shirking. One problem withthissolution topost that workers nothavethewealth may with bond."8 A morefundamental probleih thismechanism is thatthefirm wouldhave an incentive to claimthat theworker shirked so thatit could appropriate thebond. Asthatthird suming, quiterealistically, parties cannot observe workers' effort easily (indeed, to it is usuallymorecostlyfor outsiders observe worker inputs thanfortheemployer to do so),there is no simple waytodiscipline thistype ofopportunism. thefirm from thisbasic point,it is Havingrecognized ofother easyto see thata number plausible For examsolutions facethesamedifficulty. which ple,consider an employment package for rewards effort byraising wages overtime workers whohavenotbeenfound shirking. Thisis infact equivalent togiving theworker a levelwagestream, buttaking backpartof his earlierpayments as a bond, whichis tohim retumed later. Therefore, bytheabove willhavean incentive to thefirm argument, fire when he is aboutto enter the theworker his "payoff' periodin whichhe recovers to the firm's bond. This is the equivalent thebond.It is optimal simply appropriating for the firmto replace expensive senior workers byinexpensive ones."9 junior
'8Thisis especially true ifdetection is difficult (low q) so that an effective bondmust be quite large. Evenif workers could borrow to post thebond,so long as is possible, foravoiding bankruptcy theincentives deon thebondare notdifferent from theincenfaulting to avoidbeing in the tives caught shirking by thefirm absence of a bond.Noteonceagaintheimportance of in determining thewealth distribution thenature ofthe If all individuals inherit a large of equilibrium. amount wealth, then they couldpostbonds. '91ncompetitive equilibrium, theaverage (discounted) value of thewage mustbe equal to the average

thefirm's as an honest Clearly reputation solve thisproblem; employer can partially is implicitly for penalized firing theemployer himlessattractive to ifthis renders a worker Yet thisreputation prospective employees. mechanism well, may not workespecially oftendo not since prospective employees and previous knowthe employer's record, dismissals (itis not mayhavebeenlegitimate to disemployees possiblefor prospective disfrom unfair earlier tinguish legitimate if they at all). If are awareof them missals, is less thanperthe reputation mechanism it willbe augmented by theunemployfect, ment mechanism.
B. OtherCostsofDismissal

in themodelaboveserves Unemployment the role of imposing costs on dismissed If other are suffiworkers. costsof dismissal workers ciently high, mayhavean incentive to exert conditions of full effort evenunder employment. Examplesof such costs are loss of jobsearchcosts,moving expenses, where specific human capital, etc.In markets thesecostsare substantial, theroleof equiis substantially dilibrium unemployment minished. Theeffect wehaveidentified above wheneffort will stillbe present, however, levels are continuous variables:each firm willstill effort is increasfind that employee ing withwages,so wageswill be bid up level. somewhat abovetheir full-employment involuntary (as well The theory predicts that as frictional) rateswill be unemployment for whohavelower classesofworkers higher costs. job switching

value ofthe ofthe worker. (discounted) marginal product If there is a bonusfornotshirking, initially thewage be below the valueofthe must marginal product. It is as if theworker wereposting a bond(thedifference between hismarginal product and thewage), and as such thisscheme is susceptible to precisely thesameobjections raised against posting performance bondings. The has an incentive employer to appropriate the bond. Sinceworkers knowthis, thisis nota viableincentive scheme. Fora fine in which firms' study are reputations assumed to function so as to makethisscheme viable, see Edward Lazear(1981).

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C. Heterogeneous Workers we havemadeis assumption The strongest This assumption workers. thatof identical that firing a worker ruledoutthepossibility could anystigma. Sucha stigma wouldcarry evenwithfull device, serveas a discipline of course,emIn reality, employment.20 which are conployers do makewageoffers Suchpolicies on employment history. tingent of face problems make sense when firms adverse selection. concern about that workers' We recognize as effective, dilitheir reputations protecting workers an effective incenmayprovide gent laborforce.2' Shapiro's tivefora disciplined in prodofreputation earlier (1983)analysis forreputhat however, uctmarkets showed, incentive device, to be an effective tations there be a costto thelossofreputation. must that,underplausible It is our conjecture are imeven whenreputations conditions, willentailsomeuse of portant, equilibrium as a discipline deviceforthe unemployment workers. atleastfor lower-quality laborforce, is thestudy of lineofresearch An important as selection in which adverse labormarkets are present. wellas moralhazardproblems ourmodelshould a In thiscontext, provide to the more common usefulcomplement inlabormarkets. studies ofadverse selection IV. Conclusions

work, somewhich tendto makethemarket rate and toohigh, equilibrium unemployment it too small. Each others which tendto make firm failsto take into accountthe conseon thelevelof moniquencesof its actions must toring and wages whichotherfirms in order to avoid shirking undertake by are workers. Althoughthese externalities muchlike pecuniary theyare externalities, witha large important, even in economies offirms.22 wehaveargued number As a result, intervenis scopeforgovernment thatthere to unemployment tions,both withrespect on monitoring or subsidies benefits and taxes which can (if apand labor turnover, propriately designed)lead to Pareto improvements. ofunemployment studied here is The type not the only or even the mostimportant ofunemployment in practice. We besource in the lieveitis,however, a significant factor levelof unemployment, especially observed blue-collar ocin lower-paid, lower-skilled, It may well be moreimportant cupations. in thanfrictional or searchunemployment labormarkets. many
22For a moregeneral discussion of pecuniary, or more market general mediated with externalities, applicationsto economies with important adverse selection and moral hazard see Greenwald problems, and Stiglitz (1982).

theroleofunemThispaperhas explored "Proas an incentive Alchian, Harold, or job rationing, ployment, AnnenA. and Demsetz, when Costs, and Economic Information that itis costly duction, device. We haveargued American EconomicReequiOrganization," competitive to monitor individuals, December 1972,62,777-95. willbe characterized by unemploy- view, librium rateofunemploy- Calvo,Guillermo thenatural A., "Quasi-Walrasian Theobutthat ment, EcoAmerican willnot in general be ries of Unemployment," mentso engendered May 1979,69, forces at Review Proceedings, nomic several We haveidentified optimal.
20SeeBruce Greenwald a simple model in (1979)for which those whoarein the"used labormarket" arein facta lowerqualitythanthosein the "new" labor market. 21This suggests once againthatour results maybe most significant in labor markets for lower-quality workers: in such markets employment histories are lessandworkers utilized labeled as belowaveralready haveless to lose from age in quality beinglabeledas such.

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