Wage Rigidity, Implicit Contracts, Unemployment and Economic Efficiency

Implicit contract theory has been successful in explaining wage rigidity but not unemployment. We argue that the theory has paid insufficient attention to (i) the general equilibrium aspects and (ii) constraints limiting the set of feasible contracts. Implicit, as opposed to explicit contracts, must specify an enforcement mechanism, can only be conditional on observable information, and must be of limited complexity. We first show that in a simple general equilibrium model without these restrictions contracts do not result in unemployment but that the market equilibrium is not constrained Pareto efficient. Our main object is to examine the consequences of these three restrictions. Natural restrictions on enforceability or complexity alone do not lead to unemployment, but limited observability may lead to unemployment. If, however, two or more restrictions apply, then unemployment may result. In particular, we show that periodic unemployment can arise if contracts are of limited complexity and cannot be enforced through third parties.