The impact of firm failure rates on the development and nature of implicit long-term labor contracts

Abstract

Implicit long-term labor contracts provide a characterization of the employment relationship markedly different from that suggested by a "spot" labor market. Long-term implicit agreements are of considerable interest because their use is consistent with many stylized facts of the labor market, and they help to explain other observed micro- and macroeconomic phenomena not easily rationalized within the conventional neoclassical paradigm. This thesis addresses a gap in the current literature by rigorously examining the impact of various firm, worker, and industry characteristics on the development and nature of implicit long-term labor contracts.

Specifically, it is demonstrated that under certain conditions, the use of long-term implicit labor contracts is inversely related to the failure probability of firms. This result follows naturally from the shirk-deterring, end-weighted compensation scheme associated with incentives based extended contracts, coupled with worker risk aversion. Moreover, it is shown that the earnings profile under implicit contracts may also be influenced by the probability of unintentional firm default.

The theoretical predictions are uniformly supported by appropriately designed empirical tests. Based on previous research in the area, pension coverage is used as a proxy for implicit long-term contract coverage. It is demonstrated that for workers most likely to be faced with the long-term/spot market dichotomy, industry failure rates exert a significant negative influence on the probability of implicit contract coverage. Furthermore, the evidence supports several related hypotheses concerning the impact of failure rates on the earnings profile under long-term agreements; for workers taken to be covered by implicit contracts, a compensating differential related to the probability of failure was found, as is a return to tenure that is positively related to firm failure rates.