When Should a Firm Employ its Workers? A Relational Contracting Approach

A principal contracts with an agent to repeatedly perform a task. The principal can choose between two organizational forms, employment or solo self-employment of the agent. A key distinction between the organizational forms is that, under employment, the principal is allowed to stipulate how the agent performs the task, whereas this is legally forbidden under self-employment. Moreover, under employment, the principal needs to guarantee a minimum wage. Under self-employment, only a non-negativity constraint on the agent’s payment applies. First, we solve a general model for the case of a non-verifiable task outcome. We show that, if the first best is not attainable, employment leads to an overprovision of the agent’s action whereas self-employment leads to an under provision relative to the first best. If the discount factor takes intermediate values, the principal prefers employment when the agent is likely to have low costs and self-employment when the agent is likely to have high costs. Second, we consider the case of a verifiable task outcome under more specific model assumptions and focus on characterizing the range of discount factors for which the principal is able to induce the first-best under either organizational form. With a verifiable task outcome, enforceable and relational payments to the agent become imperfect substitutes. As a consequence, more attractive labor market prospects for the agent favor self-employment. In both contracting environments, increases in the minimum wage make employment less attractive to the principal