The Expectation Measure, Labor Contracts, and the Incentive to Work Hard

Under American or Dutch law, employees who leave the firm earlier than expected do not have to compensate the employer for lost profits in most cases. This conflicts with the general view in law and economics scholarship that the expectation measure is the superior remedy. We argue that the promisee (the employer) should not be awarded compensation for lost expected profits if the promisor (the employee) can vary his level of effort, which is a typical feature of labor contracts. The ex post expectation measure undermines the incentives to work hard (i.e., above the defined minimum level) because the higher the employee's productivity, the higher the expected lost profits for the employer in case of breach. Our conclusion holds even if the first employer earned rents, or if the employee likes to work, or if courts undercompensate. The ex post expectation measure improves the employee's incentives only if markets seriously overreact to productivity signals. We also analyze the incentive properties of 3 alternative expectation measures. The ex ante minimally expected profits measure does not change the incentives to work hard, but if the expectation measure is defined in terms of potential (maximal) or optimal productivity, the incentive to work hard is seriously undermined. We also show that the ex post expectation measure may create unemployment in that it inefficiently deters employees from entering into labor contracts. Contrary to the current view in law and economics scholarship we show that the expectation measure can be a barrier to efficient breaching. It destroys the information necessary for efficient breach by undermining the employees' incentives to signal on the market how productive they can be. As a consequence, competing employers no longer receive the information they need to make better proposals