Journal of Economic Theory and Econometrics: Journal of the Korean Econometric Society

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Journal of Economic Theory and Econometrics
Journal of the Korean Econometric Society

Cyclical Implications of Optimal Labor Contracts in the Equilibrium Search Model

Vol.22, No.1, March , 73–108

  •   (Department of Economics, Korea National Open University)


The optimal contract under moral hazard is embedded in a standard equilibrium search model. Under standard assumptions, we show that when firms cannot perfectly observe workers' productivity, the optimal contract takes the form of a standard debt contract. When this contract is embedded in the standard model, the calibrated model can possibly generate a more rigid wage and more volatile employment than the standard model. However, for the model to capture the observed cyclicality of employment, the largest portion of wage should be paid as a base wage which is constant irrespective of worker's performance. When the sources of wage rigidity are investigated, we find that the introduction of optimal contract setting---the absence of bargaining power and the limited incentive effect at the optimum---plays most important roles. This paper provides an endogenous mechanism for real wage rigidity even under the presence of performance-based pay, induced by moral hazard problem.

   Equilibrium Search Model, Debt Contract, Rigid Wage, Volatile Employment

JEL classification codes
   E24, J41, J64

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