Abstract

Labor contracts establishing performance related pay incur on a firm's moral hazard problem when there are no verifiable measures of performance. Some models have explored the possibility that such contracts can be enforced through a mechanism of firm's reputation. MacLeod and Malcomson (1998) show alternatively how these contracts can be enforced thanks to the existence of an excess of demand (job vacancy) on the labor markets. However, when reputation is difficult to establish and when labor markets are in excess of supply (involuntary unemployment), these mechanisms cannot be activated. In this paper, through a simple model an alternative enforcement mechanism is proposed for performance-related pay contracts based on a widely diffused form of labor market institutional rigidity: the employment protection legislation, that is, the combination of just-cause and firing costs imposed on the firms who dismiss workers. In a game theoretical structure with repeated prisoner's dilemma, these institutional rigidities combined with intrafirm reputation act as commitment devices for the firm and allow the enforcement of implicit contracts. The market equilibrium achieved is compared with an efficiency wage equilibrium and it is showed that the latter is Pareto-dominated. The model in this way shows an efficiency-enhancing role for job security provisions in asymmetric information contexts.