Christopher Foote

English

Research Papers in Economics

FEDERAL  RESERVE  BANK  OF  ST. LOUIS
69
MAY/JUNE  1999
Commentary
Christopher Foote
T
his stimulating paper by den Haan,
Ramey, and Watson (DRW) seeks to
contribute to two literatures.  First, it
helps answer the microeconomic question
of when ﬁrms will use performance pay
rather than salaries to motivate workers.
Second, it examines the microeconomic
issue of why employment relationships
appear so fragile with respect to aggregate
shocks.  The overarching goal is to show
that these two literatures are related, or, as
the authors put it, “the particular form of
imperfections that are present in the con-
tracting environment can have major
implications for economic outcomes.”
The central result of the paper is that
employment contracts often are robust
with respect to aggregate shocks only if the
effort choices of both the worker and the
ﬁrm are veriﬁable and contractable.  The
paper is exceptionally clear and insightful;
even though the model is simple, the authors
can analyze a surprisingly large number 
of special cases.  As a result, it is a great
paper for a volume that seeks an integrated
study of the macroeconomics of the labor
market.  I will comment ﬁrst on the struc-
ture of the model and then discuss its
micro and macro implications.
The nicely parsimonious model is
based around three possible exchanges
between the worker and the ﬁrm.  The 
two parties begin the period by negotiating
the contract and making an initial exchange
(sk
0), which depends on the aggregate state
k.  In the negotiation process, they promise
to make intermediate exchanges (sA and
sB) if one of the parties shirks.  Finally, 
if both parties provide the required levels
of high effort, production completes satis-
factorily and the ﬁrm receives the output,
making a ﬁnal exchange (sk
C) to the worker.
The authors contend that long-term
employment relationships can survive
even in bad aggregate states if the agents
can successfully commit themselves not 
to shirk, but this requires low effort to be
detectable by a court so that it can bring
about the required intermediate exchanges.
The setup reminded me of an unemployed
worker in the Shapiro-Stiglitz model; such
a worker would like to be hired at the pre-
vailing wage, but his offer is not accepted
because he cannot make a credible promise
not to shirk.  Here, in the case of perfect
veriﬁability, the offer is accepted even
when the production value is low because
shirking is detected with probability one
and can be proven in court.  This brings
about the required intermediate transfer
from the worker to the ﬁrm.  (Another 
difference between this model and the
Shapiro-Stiglitz framework is that in this
model the workers can post bonds for jobs
via negative values of the initial payment
sk
0, a point to which I will return below).
When veriﬁcation of effort is not possible
in the DRW model, the intermediate-pay-
ment strategy for the robust employment
contract fails.  The constant beneﬁt of
shirking is too large and tempting for either
the worker or the ﬁrm, relative to the low
outcome from production.
The model has several interesting
microeconomic implications.  But even
though the possibility of initial, intermediate,
and ﬁnal payments makes the model very
versatile, I am not sure that it is general
enough to speak deﬁnitively on the issue
of salary versus performance pay in an
optimal compensation policy.  The applica-
bility of the model for this issue hinges on
whether a negative payment to a worker in
the initial period (sk
0 <0) can be thought of
as a salary, or rather, as some sort of nega-
tive bond reﬂecting the ex ante terms of
trade in the labor market.  Because such
bonds can eliminate involuntary unemploy-
ment when effort elicitation is a problem,
such bonds have featured prominently in
Christopher Foote is an assistant professor of economics at Harvard University.MAY/JUNE 1999
FEDERAL RESERVE BANK OF ST. LOUIS
70
work of this kind.  Yet the authors claim
that in their model, a positive value sk
0 is
like a salary, while the ﬁnal payment, sk
C,
resembles performance-based pay.  There-
fore, they suggest that their model can
speak to the performance-pay versus salary
issue.  Yet the DRW model does not allow
the worker both to post a bond (which
would require sk
0 <0) and receive a salary
(which would require sk
0 > 0).  As a result, 
I am not sure that the model can be
considered a general case of the previous
models in the effort-elicitation literature.
An alternative interpretation of the salary-
vs.-performance-pay distinction in the
DRW model would be that some average
value of the end-of-production payment
(which could be denoted sC) would be
more like a salary, while the time-varying
payments (sk
C) are similar performance-
based pay.  The point is that a salary is
generally a constant payment received by
the worker regardless of how much output
is produced, yet if production does not
take place, no salary is received.
A larger microeconomic goal of 
the paper is to investigate the effects of
nonveriﬁability of effort in employment
relationships.  To make the model tractable,
the authors make some simplifying
assumptions expressed in inequality 1.  
One implication of the assumptions is 
that the promise of continuing the job 
is generally not enough to preserve a 
current match in the bad state today,
unless there is some veriﬁability of effort.
Basically, ﬁrms and workers will not 
stick it out through the bad times in 
order to enjoy the good times again later
on.  As the paper shows, however, the 
continuation value of the job in the
different states (the g’s) are themselves
functions of the common discount factor
(b), the probability of the bad state (r),
and the relative levels of the productive 
outcomes (zG and zB).  Therefore, underlying
the assumptions in inequality 1 are implicit
assumptions about preferences and the
stochastic properties of aggregate shocks.
Indeed, ﬁrms and workers may want to
endure the bad times even without veriﬁa-
bility—if the discount rate is small enough
or bad aggregate shocks are rare enough—
but particular values of the underlying
parameters, which imply that veriﬁability
is required for a robust contract, are 
not obvious.
A third comment on the micro-structure
of the model involves the relationship of
this model to work involving speciﬁc
investments in the employment relationship.
Papers by Caballero and Hammour stress
the “fundamental transformation” that
employment relationships undergo when
searching workers and ﬁrms ﬁnd one
another, or when either side of the employ-
ment relationship invests in capital that 
is speciﬁc to the match.  Both of these 
phenomena transform the employment
relationship into a bilateral monopoly
where the ex ante terms of trade may not
carry over to the ex post Nash bargain over
the surplus in the match.  In reading this
paper, I was curious to know whether
there was a simple mapping between its
shirking interpretation and the speciﬁc
capital basis of other work.  It may be that
the shirking model is a particularly strong
form of the speciﬁc capital model.  For
example, consider the type of speciﬁc cap-
ital that is created simply when a searching
worker ﬁnds a speciﬁc job.  Match capital
is created because the ﬁrm no longer has
to pay the costs of posting the vacancy and
the worker can start earning wages rather
than spend time looking for a job.  The
outside alternatives of the worker, the ﬁrm,
and the exogenously determined bargaining
weights (thep’s) determine how the surplus
is divided in both models; though in the
DRW setup, the worker or the ﬁrm receives
an additional reward (the beneﬁt to shirking)
if the match breaks up.  In the speciﬁc cap-
ital model, a party who leaves the match
does not receive this type of beneﬁt.  It
would be interesting to know if there is a
simple way to link both the shirking and
speciﬁc-capital interpretations of the
employment relationship.
One way that ex ante terms of trade
can be reﬂected ex post in the employment
match is when the workers post a bond.
One of the cases discussed by the authors
is that of “limited liquidity,” which arguesMAY/JUNE 1999
FEDERAL RESERVE BANK OF ST. LOUIS
71
that low liquidity may prevent workers
from paying a bond.  The inability to pay a
bond opens up the possibility that efﬁciency
wages may be paid in order to elicit effort.
Several economists, however, have pointed
out that the utility cost of a bond payment
may vary inversely to the worker’s liquid
assets.  Workers with low liquidity may
ﬁnd it hard to post a bond, but it is
precisely these workers who will be 
quite averse to shirking and losing their
bond if they get caught shirking.  Of
course, the power of very small bonds to
motivate liquidity-constrained workers
depends on marginal utility going to nega-
tive inﬁnity as assets go to zero, so the
outside beneﬁts, b, may prevent this from
occurring in the DRW setup.
I now turn to the macroeconomic
implications of the model.  One of the key
questions in cyclical macroeconomics is
why so many employment relationships
break up during recessions.  Pioneering
work by Davis, Haltiwanger and Schuh
showed that (at least in manufacturing)
the drop in employment that occurs when
recessions begin comes not from a decline
in the creation of new jobs, but rather, a
large spike in the destruction of existing
jobs.  Several authors have suggested that
the spike in job destruction at the onset of
recessions may be linked to the economy’s
ampliﬁcation mechanism, by which mod-
erate innovations to productivity or
aggregate demand may bring about large
movements in employment and output.
Not surprisingly, a number of theories to
explain the burst in job destruction have
been advanced.  One branch of the litera-
ture stresses “cleansing” effects of
recessions.  Large numbers of jobs are
destroyed in recessions because a large
number of jobs are typically close to the
margin of unproﬁtability at any point in
time.  Convex job-creation costs for the
aggregate economy mean that it is more
efﬁcient for these older jobs to be destroyed
than for the rate of new job creation to drop.
A second branch of the job destruction lit-
erature stresses the “pit stop” role of
recessions.  Just as the real business cycle
literature contends that recessions are a
good time to enjoy leisure, that pit-stop
view suggests that recessions are good
times to reorganize production.
This paper can be placed in a branch
of the economic literature that contends
that the increase in job destruction is a 
primary result of some imperfection or
friction in the labor market; here, the fric-
tion is nonveriﬁability.  Other papers of
this kind suggest that job destruction is
high during recessions because wages
cannot fall.  Two potential causes of wage
rigidity are the suppression of wage rene-
gotiation (since bargaining is costly and
may encourage opportunistic behavior)
and efﬁciency wages (the need to motivate
workers provides a ﬂoor through which
wages cannot fall).  The DRW model sug-
gests that nonveriﬁability, rather than the
suppression of negotiations or efﬁciency
wages, can better explain the cyclical
dynamics of the labor market.  The authors
implicitly argue against the suppression 
of the renegotiation model by having the
worker and ﬁrm bargain at the start of
every production period.  The suppressed
renegotiation models imply that the ﬁrm
and the worker would like to renegotiate
and stay together, but doing so would result
in redoing the employment contract and
thereby violate some social norm.  The
DRW paper suggests, in contrast, that
ﬁrms and workers are not averse to
renegotating, but they prefer to separate in
bad times because they cannot make a
credible promise not to shirk without
external veriﬁability.
The paper argues against the efﬁciency-
wage-model-with-veriﬁability more explicitly
with the experiments displayed in DRW’s
Figure 2.  Recall that efﬁciency wages arise
in the DRW framework if workers are unable
to post a bond and the value of the ﬁnal
payment they can receive at the end of
production is not large enough to prevent
them from shirking.  In this case, the ﬁrm
must raise the worker’s total compensation
(here, just the ﬁnal payment) above the
level implied by the worker’s bargaining
weight, pw.  In this way, the worker is
encouraged not to shirk and an efﬁciency-
wage trade-off arises.  This is due to theMAY/JUNE 1999
FEDERAL RESERVE BANK OF ST. LOUIS
72
inverse relationship between the total
compensation of the worker and his incen-
tive to shirk.  The ﬁrm is prevented from
shirking because of the veriﬁability
assumption.  Should it fail to provide high
effort, the court will assess a payment to
the worker of sA.  The efﬁciency-wage
cases analyzed in Figure 2 are, therefore,
ones of robust contracts, because the efﬁ-
ciency wage and the monitoring of the
ﬁrm by the court combine to keep the par-
ties honest.  Figure 2 shows that the three
veriﬁable contracts result in little ampliﬁ-
cation of shocks, which are modeled as an
increase in the breakup parameter r.  Even
the two contracts that imply efﬁciency
wages are robust, in part because ﬁrm
behavior can be veriﬁed.  On the other
hand, the nonveriﬁable (“severance
payment only”) contract results in substan-
tial ampliﬁcation of the increase in r.
Employment relationships break up
because no mechanism exists to ensure
high effort.
My main concern with this result 
is that I am not sure it portrays efﬁciency
wages in the most familiar way.  The
efﬁciency-wage model in this paper is
essentially backloaded compensation,
which is paid only when the worker does
not shirk, an event that is detected with
probability one.  (Of course, there may 
be an incentive for the ﬁrm to shirk when
compensation is backloaded, but the courts
are assumed to regulate the ﬁrm’s behavior
since veriﬁcation is assumed in these cases.)
Another interpretation of efﬁciency wages,
however, might afﬁrm that they arise 
when worker misbehavior is detected only
imperfectly and, therefore, the workers may
consider the shirking decision differently.
The differences in the two interpretations
for macro behavior of the two views of efﬁ-
ciency wages are not obvious immediately.
Another question I have is how general
equilibrium effects work in the macro sim-
ulations of DRW’s Figure 2.  The general
equilibrium is important because the pre-
vious work by Caballero and Hammour
has shown that high unemployment
during a recession can result from wage
rigidity engendered by speciﬁc-capital
investments.  The high unemployment 
is an equilibrium response of the economy
to wage rigidity, as it disciplines the wage
demands of insiders.  I am curious to know
whether a similar effect is operating here.
All in all, I found this paper well
worth the time and effort it took to study
the subject carefully.  And I hope the 
graduate students enrolled in my next
“Macroeconomics of the Labor Market”
course do so as well.

Contract-theoretic approaches to wages and displacement, commentary

http://research.stlouisfed.org/publications/review/99/05/9905cf.pdf

Contract-theoretic approaches to wages and displacement, commentary

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