Risk Sharing through Labor Contracts - Risk Aversion, Market Incompleteness and Employment

Abstract

Labor contracts are a way of sharing idiosyncratic production risks between entrepreneurs and workers, especially when such risks are too complex for contingent contracts to be written on them. So it is important to understand how equilibrium employment and wages are affected by risk re-lated factors, such as risk aversion of entrepreneurs and workers, risk sharing opportunities in the economy etc. The paper develops a general equilibrium model with several sectors of production which are subject to idiosyncratic productivity shocks, two inputs - labor and capital - and stock markets which diversify sectoral risks but not completely. We prove the existence of equilibrium for this general model. The model is then parameterized by CRRAutility functions. We prove that the equilibriumemployment levels vary inversely with the coefficient of relative risk aversion of agents under certain conditions. Numerical simulations show that over a range of the coefficient employment levels are higher when markets are complete than when they are not. A substantive implication of the comparative static results is that a low paying, productively less efficient alter-native to working for private firms may be desirable as an insurance instrument.