Two-Sided Uncertainty and Up-or-Out Contracts (1988)

NORC at the University of Chicago
The University of Chicago
Two-Sided Uncertainty and "Up-or-Out" Contracts

Author(s): Charles Kahn and Gur Huberman
Source: Journal of Labor Economics, Vol. 6, No. 4 (Oct., 1988), pp. 423-444
Published by: The University of Chicago Press on behalf of the Society of Labor Economists and
the NORC at the University of Chicago
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Two-sidedUncertainty
and
"Up-or-Out" Contracts
CharlesKahn,University
ofIllinoisat Urbana-Champaign
Gur Huberman,University
ofChicago
and Tel Aviv University
A bilateralmoral-hazardproblemprovidesa rationalefor "up-or-

out" employmentcontracts.The employersets a wage higherthan
opportunity costto inducetheworkerto investin firm-specific capital.
If the individualdoes not make the grade,it is in the firm'sinterest
ex postto firehim.Had theinitialarrangement notincludedprovisions
forfiringindividuals,the firmwould underreport the value of the
employee,wreckingthe incentivescheme.The basic model permits
both firmand worker to be risk neutral.Therefore,it admits a
straightforward multiperiodextension,whichwe also investigate.
In manyorganizations, ifpromotiondoes notoccurwithinsome settime,

individualsare not retainedeven when it would appear productiveto do
so. In some industries,
thepolicyhas a distinctive
name:achievingtenure
ormakingpartner. In otherprofessions-forexample,themilitary-similar
cutofflevelsor probationary periodsappeareventhoughno specialname
is attachedto them.
Partofthisresearch
wasdevelopedwhilethefirst
authorwasa nationalfellow
at theHooverInstitution,
Stanford We aregrateful
University. to theNational
ScienceFoundationforsupportunderGrantSES 851138.
[JournalofLaborEconomics,1988,vol. 6, no. 4]
? 1988 byThe University
of Chicago. All rightsreserved.
0734-306X/88/0604-0005$01.50
423
424 Kahn/Huberman
We develop a simplecontracting frameworkthatprovidesa rationale

forsuch "up-or-out"policies.Our structure
uses two-sideduncertainty,
withbothfirmandworkersubjectto a moralhazardproblem.
The idea
can be summarized
as follows:theemployer
setsa wagehigher
thanop-
cost in orderto inducetheworkerto investin makinghis pro-
portunity
ductivity
highenoughto be retained.
Iftheindividual doesnotmakethe
to firehim.If theinitialarrangement
grade,thefirmprefers had notin-
cludedprovisions
forfiringindividualswhodo notmakethegrade,the
firmwouldunderreport thevalueof theirlabor,thereby wreckingthe
incentivescheme.
Involuntarytermination ofemployment poses a difficulty
foreconomic
theory:in a worldof completeinformationthereis alwaysa spot market
arrangement thatachievestheefficient
employment allocationsvoluntarily.
It is notclearwhyjuniormembers
ofa firm
aretoldto leaverather
than
beingoffered thejob at reducedwages. It is natural,therefore,
to look for
an information-based incentiveargumentto explainup-or-outlabor ar-
rangements.1
SectionI containsa two-stateexampleto illustrate theintuition.Section
II examinesa continuous-state model in greaterdetail,notingthe factors
thatencourageup-or-outcontracts.SectionIII solves a multiperiodex-
tension.It predictsthatthe barriersto promotionbecome more severe
throughthelifeof thecontract.SectionIV treatsriskaversion.SectionV
considersmodificationsto the informationstructure.The final section
comparesour model with otheroptimal contractingmodels and notes
some advantagesand limitations of our approach.
i. A Two-StateExample
A workeris consideringan attachment to a particularfirm.His output
at thatfirmwill be a randomvariable,whichmaytake a highvalue h2or
a low value hi. By makingan investment in specifichumancapital,the
worker
canincrease
thelikelihood
ofthehighproductivity
draw.Letf(1)
be theprobabilityof highoutputiftheinvestment
is made andf(O) be the
ofhighoutputiftheinvestment
probability is notmade.Thusf(1) >f(O).
The investment ithas no valueiftheindividual
is assumedfirm-specific;
does notworkforthefirmaftertheinvestment
has beenmade.We assume
thatthelevelofproductivity
to be achievedis learnedbeforetheworkis
actuallydone,so thatin principlethedecisionto workor notcan be made
'
Hashimoto(1979), among others,positscosts to writinglabor contracts and
therebyexplainsinvoluntary employment separationsin a full-information world.
In thiscase, wages are optimallyset ex ante,butresolutionof uncertainty about
productivityand alternative
opportunities resultsin layoffs
or quits.This is a natural
explanationin extremelylarge firms,where it may be cheaper to firea single
workerratherthanwritea customizedcontract.This explanationis less plausible
forsmaller
firms
orforhighly
specialized
workers
ina largefirm.
Contracts
"Up-or-Out" 425
contingent on thedraw.However,we also assumethatbothh2and hi are

greaterthanthevalue oftheopportunity costoftheworker'slabor,which
we will call r. We assumethattheopportunity costof thefirm'sresources
is zero; iftheindividualis not retained,thefirmproducesnothing.
Bothfirmand workerare riskneutral.Let thepositivenumberi be the
cost of the investment to the worker.We are interestedin dealingwith
thecase whereit is productively efficient
fortheinvestment to be under-
taken.Thatis, theexpectedproductivity oftheinvestmentmustbe greater
thanitscost or
Z [f(1) -f(O)](h2 - hi) - i > 0. (1.1)
The quantityZ is thenetsocial gainyieldedby theinvestment.

We now proceedto describevariousinformation thatcould
structures
obtainin thismodeland thecontractualstructures thatwould resultfrom
each (foranother,simplerexerciseofthissort,see Hall and Lazear [1984]).
In all cases we assumethatthereis somelevelofutilityv theworkercould
receivehad he not signedup with the firm,and thattherefore the firm
mustfindthe contractthatmaximizesits expectedprofitssubjectto the
constraint thattheworker'sexpectedutilitybe at leastv.
Suppose thatthe individual'sinvestment can be observedby the firm
and an enforcement agency.Then the standardtheoriesof firm-specific
humancapitalwould predictan outcomein whichtheemployercompen-
satestheindividualforanyinvestment he makes.Given(1.1), theefficient
contractwrittenex ante will specifythat the individualundertakethe
investment. It will specifythattheworkerproduceforthefirmno matter
whatthedrawof productivity maybe. Finally,it will specifypaymentto
theworkerequal to v + i.
Many articleshave investigated theproblemthatoccurswhen thepro-
ductivity of an individual'slabor is information thatis privateto thefirm
(Chari [1983],Cooper [1983],Greenand Kahn [1983],Brownand Wolf-
stetter [1985],to namea few).Normally,attempting to implement a contract
suchas thatdescribedabove in thepresenceof privateinformation would
resultin problemsof adverseselectionsincethefirmwould normallyfind
it in its advantageto manipulatethe information it providesabout the
levelof productivity. Note, however,thatin thisparticularexample,the
difficulty does not arise. No matterwhat the draw of the productivity
parameter, it is alwaysoptimalforthe firmto retainthe individualsince
heis neveras productiveoutsideas he is insidethe firm.Thus the full-
information contractdescribedabove is incentivecompatibleeven if the
productivity drawis information thatis privateto thefirm.
Next we considerthecase wheretheproductivity draw remainspublic
information but the investment chosen by the workeris not observable
by the firm.In structure thisis a straightforwardmoralhazard problem
426 Kahn/Huberman
(Ross 1973,Holmstrom1979).Full insurancebecomesimpossiblesinceit

leavestheagentwithno incentive
to maketheinvestment in capital.Instead,
compensationmustbe tiedpartiallyto performance withhigherproduc-
tivityreapinga reward.Nonetheless,the individualis stillretainedin all
circumstances.
Let Y2 and yi representthe pay offeredin thetwo realizations.For the
workerto choose to invest,it is necessarythat
f(1)y2 + [1 - f(l)]yi - i 2 f(O)y2 + [1 -f ()]yi. (1.2)
For theworkerto acceptthecontract,it is necessarythat
f(l)y2 + [1 -f(1)]yl - i 2 V. (1.3)
Together,thesetwo conditionstreatedas equalitiesdeterminelevelsof

Y2 and yi thatwill maximizethefirm'sprofitscontingenton coercingthe
workerto invest.Note that
y2>v+i>v>y1. (1.4)
It remainsto be determinedthatthe contractentailsa higherprofitthan

thebestof thecontractsthatdo not forcea workerto investeffort.Thus
we requirethat
f(1)(h2- y2) + [1 - f(1)](h - yi) ? f (O)h2+ [1 -f(0)]h, - v. (1.5)
This conditionreducesto (1.1); providedtheinvestment

is sociallypro-
ductiveand agentsare riskneutral,moralhazard alone createsno ineffi-
ciencies.
Thus we see that,forthe problemwe are examining,when only one
partyhas privateinformation optimalcontractsyield employmentin all
states.When both sides have privateinformation, thiswill no longerbe
thecase.
Consider the problemwhen the worker'sinvestmentdecision is not
observableby the firmand the productivity draw thatoccurs is not ob-
servableby theworker.In orderto ensurethattheworkerfindsit advan-
tageousto investin humancapital,the employeemustreceivea reward
whenthehighproductivity stateis realized.But ifproductivity levelsare
notpublicinformation, thenthefull-employment contract(yi, y2) described
above is not incentivecompatible.The contractspecifiesthattheindivid-
ual's paymentwill varywithproductivity but his employmentwill not.
The firm'sex post incentiveis alwaysto claimthattheproductivity draw
was low. It therebyreducesits paymentto the workerwithoutlosing
any labor.
Contracts
"Up-or-Out" 427
If we assumethatthird-partypayment is notpermitted as partofthe

contract,thenone way to getthefirmto declaretruthfully whenthe
worker's ishighistowritea contract
productivity underwhichtheworker
doesnotworkforthe firmwhen productivity in these
is low. Intuitively,
contracts,thefirm'swageoffers varywithproductivity in orderto en-
courageindividualinvestment.In turn,dismissalof thosewho do not
"makethegrade"is necessarytodemonstrate thatthefirm's rewardstruc-
turedoesindeedvarycorrectly withproductivity. We willcallsuchcon-
contracts.
tracts"up-or-out"
THEOREM 1.1. Let thepair(y1, y2) definean up-or-out in
contract
whichY2is thepay associatedwithretainingtheworkerand yi is thepay
associatedwithdismissingtheworker.The contractis profitmaximizing
in thesetof up-or-outcontractsifand onlyif(y1, y2) satisfythefollowing
conditions:
f(1)y2 + [1 -f(1)]y, + r-i = vI
h2 ' y2 - y1 ? h,
Y2 - Y1 2 i/[f (1) - f(0)].
if
In particular,
i/[f(1) - f(O)] > h2, (1.6)
thenno up-or-outcontractcan be implemented.

When up-or-outcontractsexist,theymustbe comparedwiththe full-
employment contract(whichdoes not induceinvestment).
THEOREM 1.2. An up-or-outcontractdominates full-employment
contractsifand only if
Z > [1 - f(1 )](h - r). (1.7)
RememberthatZ is thesocial benefitof the investment underfullinfor-

mation.Thus thisconditionindicatesthattherearecircumstancesin which,
althoughthe investment would be sociallyproductiveunder full infor-
mation,it is not desirableto induce it undertwo-sidedimperfectinfor-
mation.
II. The General 1-Period Model
Considerthefollowingrelationbetweena workerand a firm.The worker

choosesa levelofinvestmentx froma compactsetX. Investment costsix,
where i > 0. The worker'sproductivityh is a randomvariablewhose
428 Kahn/Huberman
probability
distribution
function
isF(hIx). Increased
investmentincreases
theemployee's inthesenseoffirst-order
productivity stochastic
dominance:
forxl < X2, F(h Ixi) > F(hl X2), (2.1)
forall h in thesupportof F. Assumethesupportof F does notvary

withx.
Theinvestment
x ismadeandobserved
bytheworker
only.Theworker's
productivity h is observedby the firmafterthe investmentbut before
actualproductiontakesplace.Thusthefirmhas an opportunity to terminate
therelationbeforeproductionoccurs.If theworkeris dismissed,he pro-
duces r in home production,and the firmproducesnothing.Both firm
and workerare riskneutraland seek to maximizeexpected(individual)
gain fromtheemploymentrelation.
The employment contractis signedbeforetheworkerchoosesx. It spec-
ifiesthattheworkerreceives ifhe is dismissedand s + w ifhe is retained.
We do not allow paymentsto or fromthirdparties(see Moore 1985).
Givenan employment contract(s,w), a firmchoosesa cutoff
productivity
levelk, retainingtheworkerifh exceedsk and dismissinghimotherwise.
The firm'sprofitsare h - w - s if the workeris retainedand -s if he is
dismissed.The firm'sexpectedprofit,giventhe contract(w, s) and the
choicex, is
P(w, k,x) = f (h - w)dF(hlx) - s. (2.2)
Thus theprofit-maximizing
choice of k sets
k = w. (2.3)
Given k, the probabilityof retentionis [1 - F(k Ix)]. Let the function

U(., ., .) denote the benefitthe worker anticipates from a contract. Then
U(w, C,x) = (w - c)[1 - F(w Ix)] - ix + s, (2.4)
wherec is theopportunity
costoflabor.(In the 1-periodmodelthisequals
thevalueofhomeproductionr; in themultiperiod modeldescribedbelow,
therelationbecomesmorecomplicated.)The workerchoosesx to satisfy
x E arg max U(w, c, x). (2.5)
LEMMA 2.1. The choice of x in (2.5) is nonincreasing

in c.
Proof Suppose c2 > ci, and xj is the optimumchoice of x givencj.
Contracts
"Up-or-Out" 429
Then
U(w, c2,x2)2 U(w, c2,xI),
and
U(wv,c, xI) 2 U(v C, x2).
Addingthe two inequalities,substituting

thedefinition(2.4), and simpli-
fyingyields
(c - c2)[F(wlxi)- F(wlx2)] 0.
The conclusionfollowsfromtheapplicationof (2.1).

The ex ante expectedsocial gain fromthe employmentrelationis the
sumP + U or
J(k,c, x) = f (h - c)dF(hlx) - ix, (2.6)
wherek is the employmentcutoffpoint.The level of employmentcom-

pensationw in theemployment
contract(s,w) is determined
cooperatively,
ex ante,to
maxJ(k,c,x) (2.7)
subjectto (2.3) and (2.5). (Note that the base compensations does not
affecttheproblemsinceit does not affectthesocial gainJ and it does not
affectthe choices of x and k. In effect,the base level s is simplya side
paymentchosenex anteto givetheworkerhis reservation level of utility
whenthecontractis signed.)
Thereare two typesof solutionto problem(2.7). In thefirst, x = 0 and
w = c, the opportunity cost of labor.Thus the firmemploysthe worker
in preciselythosecases in whichit is productively efficientto do so. The
worker,however,is indifferent betweenbeing employedand not being
employedand therefore has no incentiveto investin improvinghis pro-
ductivity. This is theoptimumfull-employment contract.
It is immediatethatto inducea positivex, w mustbe greaterthanc. If
two valuesof w bothinducea givenlevelofx, the lowerof thetwo does
so with less productiveinefficiency. Thus for each level of positivein-
vestment, we findw*, the minimumlevel of w thatinducesat least that
amountof investment. More precisely, w *(x; c, i) is theminimumw such
that for some x* ? x,
430 Kahn/Huberman
[F(w lx') - F(wlx*)](w - c) 2 i(x* -x') for all x' < x. (2.8)
Definew * to be infinity if no w satisfies(2.8).2Note thatw * > c. Since

thewage is greaterthantheopportunity cost,employmentopportunities
are beingmissed,but thechanceof a highwage inducestheemployeeto
invest.These are up-or-outcontracts.
LEMMA 2.2. w*(x; c, i) is weaklyincreasingin all arguments.
Proof: Suppose thatfora giventriplex, c, i, thereexistssome x* > x
and somew * thatsatisfy(2.8). Then thesamepairx *,w * will satisfy(2.8)
ifi is reduced,or ifc is reduced,or ifx is reduced.Thus theminimumw *
satisfying theconditionmustbe at leastas low.
The full-employment contractdominatesall up-or-outcontractsifand
onlyif
J(w*(x),c, x) <J(c, c, 0) forall x > 0. (2.9)
Ifx werepublicinformation,
thenpositiveinvestment
would be inefficient
if
J(C,C,X) < J(C, C, 0). (2.10)
If investmentis inefficient
in thesenseof (2.10),thenup-or-outcontracts
are neveroptimal.However,thereare caseswhereup-or-outcontractsare
suboptimaleven ifinvestment would be efficientunderfullinformation.
THEOREM 2.1. Thereexistsa levelofinvestment costi * suchthatsome
(no) up-or-outcontractdominatesthefull-employment contractifthecost
of investmentis less than(greaterthan)i'*.
Proof Upon substitution of thedefinition ofJ,(2.9) becomes
fwcfJ~ci(h-c)dF(hlx)-ix-f (h-c)dF(hIO) < 0. (2.11)
For eachx, theleftside is weaklydecreasingin i. Definei * as theinfimum

of values of i satisfying
(2.11) forsomex.
Theorem2.1 statesthatup-or-outcontractswill be observedwhenever
thecost of investment is less thansome criticalleveli'*. We will say that
a change in some exogenousvariablemakes up-or-outcontracts"more
likely"ifit increasesi* and "less likely"ifit decreasesi'*.
THEOREM 2.2. SupposeX = {O, 1}. Then up-or-outcontracts become
2
To ensurew* is welldefined,
it is sufficient
to assumethatthedistribution
F areuniformly
functions continuousinx.Evenifw* isnotwelldefined,analogous
canbeobtained
results byreplacing"minimum" with"infimum" inthedefinition
ofw*.
"Up-or-Out"
Contracts 431
F(. I1) improvesor the distribution

at least as likelyif the distribution
F(. I0) worsensin the senseof first-order
stochasticdominance.
Proof ImprovingF(. I1) or worseningF(. I0) directlyincreasesthe left
side of (2.11). Furthermore, by an argumentanalogous to the proofof
lemma2.2, eitherchange reducesw*, further increasingthe leftside of
(2.11). For the expressionto remainequal to zero, i* mustincrease.
In otherwords,if the productivity of the investment increasesor the
productivity in theabsenceoftheinvestment decreases,up-or-outcontracts
become more tempting.Moreover,theycan be achievedmore cheaply
since the likelihoodof not makingthe grade decreases.As the cost of
investment increases,it is increasingly
unlikelythatup-or-outcontracts
will be observed.However,thosethatare observedwill containmoreand
morestringent cutoffs.
We have seen that,if the opportunitycost of the employee'stimein-
creases,thenw * increases.Moreover,itis easyto see that,iftheopportunity
cost of timeincreases,the investment in effortis less productivesocially
underfullinformation. However,we cannot concludethatup-or-outcon-
tractsbecomeless likelyunlesswe add additionalconditions;3 the choice
of optimalx in the second-bestcontractis not generallymonotonicin c.
This is trueevenin thesimplestcase whereX takeson onlythetwo values
{O, 1}; indeed,it is not difficultto build examplesin which the optimal
contractoscillatesrepeatedlybetweenx = 0 and x = 1 as theopportunity
cost c increases.4
III. A Multiperiod Extension

The atemporalmodeldescribedso fardemonstrates someofthefeatures
of up-or-outcontracts.Other significant however,are explicitly
features,
In manyjobs, reviewsforpromotionoccurintermittently.
intertemporal.
In thecasewhereX = {O,1}, a sufficient

condition inc to make
forincreases
up-or-outcontractsless likelyis F(w * I 1) - F(c I0) < 0.
4 Forexample,assumethatF(H Ix) is characterized bythefollowing of
family
discrete
probability
densities, parametrized bythetriple(B,f,N):
Pr{h = Hjx} = 1-Nf-xB H =O

= f H =1, 2,. ... N.
= xB H= n + 1,
= 0 otherwise.
ForeachN letB = 1/(2N2 + 1);f = NB; andi = BI whereI = (2N + 1)/(2N + 2).
Then,as c varies,theoptimalcontract oscillatesrepeatedly
betweenx = 0 andx
givenN, forall n = 1,... , N- 1, an up-or-out
= 1. In particular, contractis
optimalforc in theinterval(n - 1, n - I), buta full-employment contractis
optimalforc insomeinterval(n - I, n - I + e). Similar canbe generated
examples
forcontinuous distribution
functions.
432 Kahn/Huberman
The employee'srisk of termination is not invariant;rather,it increases

significantlyat thesereviewperiods,remaining low otherwise. Thesereview
periodsare also associatedwithlargerjumps in wages as the promotion
occurs.Nor is itclearin manyprofessions thattheactivities oftheindividual
changesignificantly withthepromotion.Finally,in manyprofessions, the
reviews,when theydo occur,become more and more stringent, so that
smallerand smallerproportionspass to thenextlevel.5
In thissectionwe developan intertemporal extensionthatcapturestwo
of these features:the optimal contractallows intermittent reviewwith
involuntary terminations, and successivereviewsrequirehigherand higher
standards.
Our multiperiodmodel will allow investment and productivity draws
in each period.For simplicity,assume thatthe worker'sproductivity is
intertemporally independentand thathis periodt investment affects
only
thedistribution of his productivity in thatperiod.Moreover,theproduc-
tivityshocks are intertemporally identicallydistributed(conditionedon
theinvestment decision).6Finally,we restrict themodelto thecase where
X = {O,1}.
The T-periodproblemdescribesa dynamicrelationbecausewe assume
thata workerwho is firedcannotbe rehiredbythefirm.Sinceprofessionals,
once dismissed,typicallydo not returnto theirfirms,this assumption
seemsreasonableas a firstapproximation.It impliesthatboth the firing
decisionand the employee'sinvestment decisionat timet influencesub-
sequentprofits.The multiperiodemploymentcontractwill takethesein-
fluencesinto account.
A contractstatesa wage in each period,leavingit to the employer's
discretionwhetherto retainthe workerin any period.If we assumepa-
rameterssuch thatit is alwaysproductively efficient to retaintheworker,
an up-or-outcontractin anyperiodis one thatnonethelessgivesa positive
probability oftermination. More generally, itis one in whichwagesexceed
productivity and termination is involuntary on thepartof theworker.
The contractis mutuallyagreedupon at theoutset.Given thecontract,
firmand workerengage in a sequentialgame in which the individual
choosesa sequenceofinvestment levelsxtand thefirmchoosesa sequence
of termination The termination
strategies. strategies can be represented by
a sequenceof criticalproductivity levels,kt,such thatthefirmterminates
theworkerin periodt ifhisproductivity is belowkt.Bothagents'strategies
mustbe timeconsistent.
' This lastpropertyis not universal.Nor does it necessarilyariseat theverytop
ofthehierarchyevenifitdoesholdat lowerlevels.A referee
hassuggested
that
towardthetop of thehierarchythelimitation
in thenumberof jobs available
indetermining
dominates structure.
contractual
6 We makethesimplifyingassumptionthatthepayoff doesnotin anyperiod
ofpayoffs
dependon realizations in previous
periods.
"Up-or-Out"
Contracts 433
In thenextsubsection(Sec. IIIA), we formulate and studythe2-period

problem.The main result(proposition3 below) simplifiesthe dynamic
problemto theextentthatthecomparative staticsfromtheprevioussection
can be applied to derivepropertiesof the T-period dynamicproblem.
These are outlinedin thefollowingsubsection(Sec. IIIB).
A. The 2-PeriodProblem
Let wt,xt,ktdenotethe wage, the investment level,and the cutoffre-
in period t (t = 1, 2). An asterisknext to a
tentionpoint,respectively,
variableindicatesthevariable'sequilibriumvalue. Let 6 representthe 1-
perioddiscountrate.
At thebeginning ofperiod1,theexpectedjointbenefitfromtherelation,
giventhecontractand choicesxtand kt,is
J[hi - ri) + 6 (h2- r2)dF2(h2 Ilx)-ix.

Ix2)- 3ix2]dFi(hi (3.1)
Using the previoussection'sdefinitionsof 1-periodutilityU and joint

we rewritethe2-periodjointbenefitas
benefitsJ,
f (hi - k1)dFi(hI1x1)+ U(k1,ri - 3J2,x1), (3.1a)
whereJ2is thesecond-periodjointbenefit
J2=J(k2,r2,x2). (3.1b)
From theprevioussectionswe can inferthatthefinalperiodchoicesare
k2 = w2, (3.2)
and
42*= arg max U(w2,r2,x2). (3.3)
Note, therefore,that optimal x2 does not depend on w1. Let P2*(w2)

- P(w2,k*, 4X*(w2)),themaximizedpresentvalue of second-periodprofits
giventheworker'soptimalchoice ofx* and the firm'soptimalchoice of
kO. Then we can definethefirst-periodstrategies:
= argmax - w1 + P *(w2)]dF(h, w - P*(W2), (3.4)

k* [hi xi)'=
x = argmax U(k , r1- 6J2, x1). (3.5)
434 Kahn/Huberman
The opportunity costto theworkerofstayingwiththefirmis no longer

ri. Instead,thevalue of home productionmustbe reducedby thepresent
value to theworkerof thecontinuedrelation.
In summary,(3.2)-(3.5) describethe behaviorof the individualsgiven
thecontractwi, w2.The contractis chosento maximizethe2-periodjoint
returns(3.1) subjectto theseconstraints.
The followingtheorem(theorem3.1) is themainresultin thissection.
THEOREM 3.1. Supposein the 1-periodproblemtheoptimalwage level
is w. Then w remainsthe optimalsecond-periodcutofflevel in any 2-
periodproblemwiththesame distribution.
This resultis notimmediate:becauseoftheincentiveeffects theproblem
is not separable.In the2-periodproblemit is not apparentthatwe could
myopicallypickw2withoutregardto first-period considerations sincethe
choice of w2 affectstheemployee'schoice of xi. The abilityto make this
separationdependson thefactthat,in any constrainedoptimumforthis
model,effort is providedat less thansociallyoptimallevels.
Proof. Let (w *, w*) be a candidateforan optimalcontract.Suppose
J* is thejoint productfroma 1-periodcontractwithwage w*. LetJ**
>J* be thejointproductfroma 1-periodcontractwithsome otherwage
w2** The theoremis provedifwe finda w l**suchthatthe2-periodbenefit
fromthecontract(w**, w**) beatsthatfrom(w *, w *). To do so, choose
w** = w* - P*(w*) + P*(w**). Denote choices of x and k underthe
two contractsby singleasterisksand double asterisks,respectively. Note
thatk* = k**. By lemma2.1, xl* > xl. Therefore,the distribution of h
underxl** stochastically dominatesthedistributionunderx l, so thatthe
firsttermof (3.1a) is at leastas greatunder(w**, w**). Also note that
2, r - aj**, x**) 2 U(k**, - a3** xl)

ri
= 4)>
U(kl, ri - 3J**x U(kl, ri - J*, x),
so that the second term in (3.l a) is strictlygreaterunder contract
(w I, W2 )
B. The MultiperiodProblem
Theorem3.1 impliesthatthe multiperiodproblemmay be solved re-
by pickingthe optimalw's in the last period,thenin the next-
cursively,
to-lastperiod,and so forth.Theorem3.2 below is an immediateconse-
quence.
THEOREM 3.2. In the multiperiodmodel,in any periodin which in-
vestment does not occur,wage plus presentvalue of stayingwiththefirm
equals outsideopportunity-thatis, dismissalsare voluntary.
The followingelementary observationis keyto examiningthedynamics
of themultiperiodproblem.
"Up-or-Out" Contracts 435
LEMMA 3.2. >

JtN+
J* I
Inother
words,additional
periodsinthemodelincrease thejointproduct.
we
Therefore, canexaminethepattern ofcontracting behaviorovertime
simplybyusingthecomparative staticsexamined in the1-periodcaseas
theopportunity
costc changes:
additionalperiodsinthecontract increase
thevalue of continuingthe contract,whichis equivalentto reducingthe
opportunity costofcurrentemployment. Giventhisobservation, it is easy
to generateexamplesin whichperiodsof up-or-outcontracting-positive
investmentand involuntarydismissal-are interspersed with periods of
full-employment contracting-only voluntary dismissal and no in-
vestment.7
THEOREM 3.3. In the multiperiod model,forany 2 periodsin which
investment occurs,dismissalis at leastas likelyin the laterone.
Proof. By lemma2.2, w*(1; c, i) is increasingin c.
Althoughtheinefficiency need not disappearin finitetime,it does get
smalleras moreand moreperiodsare added sincethe threatof dismissal
can becomearbitrarilysmall.In thisformulation, investment occursonly
in periodsin which thereis positiveprobabilityof dismissal.To obtain
modelsin which futurethreatscan yield investment todaywe will need
to includeintertemporal
dependenciesin returnsto investment.
IV. Risk Aversion
In this sectionwe examinethe effectsof risk aversionon up-or-out

contracts.To do so we returnto the 1-periodmodel.We assumetheem-
ployee'sutilityfunctionis
u(y) - xi,
wherey is monetary compensation, andu is an increasing

concavefunction.
Oftenit will be convenientto use the inverseof the u function;we will
denotetheinverseby Y(.), an increasing,convexfunction.We assumethat
thereis some levelof utilityv theworkercould receivehad he not signed
up withthe firm,and thattherefore the firmmustfindthe contractthat
maximizesits expectedprofitssubjectto the constraintthattheworker's
expectedutilitybe at leastv.
Again,we are interestedin the case in which,underfullinformation,
theinvestment would be sociallydesirable.That is, theexpectedproduc-
7An easywayto do so is to usea distribution

fromthefamily describedinn. 4
aboveandanextremely highdiscount rate.Then,addingadditional
periodsatthe
endmakesthefuture benefits increaseslowly,so thatc increases
slowlyas the
horizonrecedes.
436 Kahn/Huberman
mustbe greaterthantheincreasein incometo the

tivityof theinvestment
workernecessaryto compensatehimfortheinvestment:
f h-rdF(h I 1)-J h-rdF(h IO)-[Y(v +i)-Y(v)] O. (4.1)
Underriskaversiontheproblemto be solvedis
max f (h - w)dF(hlx) - s, (4.2)
subjectto
F(wlx)u(s+ r) + [1 - F(wlx)]u(s+ w) 2 v + xi, (i)
and
F(w Ix)[u(s+ r) - u(s + w)] - xi

F(wlx')[u(s + r) - u(s + w)] - x'i forall x' in X.
The constraint (i) is theminimumutilitylevelfortheworker;letv denote

the associatedLagrangemultiplier.Constraint(ii) describesthe worker's
incentiveproblem;let g denotetheassociatedLagrangemultiplier.
The followingtheoremsconsiderthe case whereX = {O, 1}. To solve
themaximizationproblemwe findthesolutionsforthecase wherex = 0
(fullemployment) and x = 1 (up or out) and comparetheoutcomes.The
solution forx = 0 is simple, for then w = r and s = Y(v) - r.
THEOREM 4.1. The solution to problem(4.2), if x = 1, is the pair
(w,s) satisfying
F(wI l)u(s + r) + [1 - F(wI 1)]u(w+ r) = v + i, (4.3)
[F(w 10)- F(wI 1)][u(s+ r) - u(w + r)] = -i. (4.4)
If morethanone pair satisfiestheseequations,thenit is thepairwiththe

minimumvalue forw.
Proof: Define G(h) = F(h 10) - F(h I1). For the case wherex = 1, the
followingare thefirst-order
conditions:
-[1 - F(wI 1)] + v{F'(wI 1)[u(s+ r) - u(s + w)] + [1 - F(wI 1)]u'(s+ w)}
+ g{G'(w)[u(s + w) - u(s+ r)] + G(w)u'(s + w)} = 0,
"Up-or-Out"
Contracts 437
and
-1 + v{F(wI1)u'(s+ r) + [1 - F(wI 1)]u'(s+ w)}
+ tG(w)[u'(s+ w) - u'(s + r)] = 0.
Fromthesecondof theseconditionswe can deduceimmediately thatv

is positivesincethethirdtermin theequationis nonpositive.Furthermore,
we can deduce thatp. is positiveas well. If it is not,the two conditions,
when combined,yieldthefollowingequation:
[1- F(w I1)]F(wI1)[u'(s+ w) - u'(s + r)]
-F'(wI 1)[u(s+ w) - u(s + r)] = 0.
Since thedifferences in thevaluesof u mustbe of the oppositesignfrom

thedifference in value of theirderivatives,
theentireexpressionis satisfied
onlyifw equals one of thetwo extremesof thedistribution. But we know
thatin thiscase thesolutionwithx = 0 mustdominatesincein neitherof
theextremecases are theincentiverequirements specifiedin condition(i)
satisfied.
If bothmultipliers arepositive,itfollowsthatw and s maybe calculated
by treatingthe two conditionsrestricting the maximizationproblemas
equalities.Equations (4.3) and (4.4) are simpletransformations of those
conditions.
Theremaybe multiplesolutionsto thispairof equations.If so, theone
withthe lowest level of w is most desirablebecause,along the locus of
pairs of (w, s) yieldingthe employeeconstantutility,the firm'sprofits
decreaseas w increases.
THEOREM 4.2. The up-or-outcontractis optimalif
f(h-w)dF(hl 1)-s > (h-r)dF(hIO)-Y(v). (4.5)
Proof The inequalityis simplya comparisonof the profitsin the

two cases.
Comparativestaticsresultsare similarto those in the 1-periodrisk-
neutralcase: up-or-outcontractsare optimalwhen investment costs are
less thansome criticallevel.In addition,increasesin riskaversiondue to
decreasesin themarginalutilityof incomeat levelsabove v + i decreases
thelikelihoodofup-or-outcontracts.Essentially, it becomesmoreexpen-
siveto offertheworkersufficient rewardto encouragetheinvestment.
438 Kahn/Huberman
V. Costly Informationand Third-Party Payments

In thissectionwe willexaminealternate formulations oftheinformation
structure in orderto determine therobustness oftheup-or-outformulation.
We make thefollowingmodification to theproblemof SectionI. Deter-
minationofoutputvaluebythefirmis no longercostless;insteaditrequires
investment of an amountm. This investment is an action privateto the
firm;it is undertakensimultaneously withtheprivateinvestment in pro-
ductivity by theworker.As before,information on productivity is private
to thefirm.
Again,we can examinethe space of contracts;theseconsistof pairsof
paymentsand labor-allocation decisions.Unliketheinitialmodel,we now
allow paymentsnotonlyto theworkerbutalso to thirdparties.We denote
paymentsto thirdpartiesbylowercasez's. Sincethirdpartiesareotherwise
passive,theywill not entera contractunlessit yieldsexpectedpayments
thatare nonnegative.
The firmchooseswhichofthetwopairsofprespecified laborallocations
and paymentswill result.If the firmhas investedin information, it will
choose whicheveroutcomeis moredesirablegivenits information. If the
firmhas notmadetheinvestment, it will simplychoosetheoutcomewhose
ex anteexpectedvalue is greatest.
By arguments parallelto thoseof theinitialsection,it is easyto see that
only two sortsof contractswill be of interest.In the full-employment
contract,theworkeris alwaysemployedat his opportunity cost.The firm
does not investin information; the workerdoes not investin increasing
thelikelihoodofhighproductivity. No paymentsneedbe madeto or from
thirdparties.The otherpossibility is an up-or-outcontract.In thiscontract,
bothworkerand firmmaketheirinvestment. The workerwill be retained
iftheoutcomehas highproductivity and not otherwise.The optimalup-
or-outcontract(y1, Y2, z1, z2) solvesthefollowingproblem:
maxf(1)(h2- Y2 - z2) + [1 -f(1)](-yi - al)
subjectto thefollowingfiveconditions:
f(1)y2 + [1 -f(1)]yl - i ? v, (5.1)
Y2 - Y1 2 i/[f(1) -f(O)], (5.2)

f(1)z2 + [1 -f(1)]z1 2 0, (5.3)
h2- ? Y2 - Y1 + Z2- z1, (5.4)
Y2- Y + z2 - Z1 2 h + 1 _f(1) (5.5)
"Up-or-Out"
Contracts 439
The firsttwo conditionsare therequirement thattheworker'sexpected

paymentequal his reservation leveland thatthedifference in paymentsif
retainedor not be sufficient to give him the incentiveto invest.These
restrictions used in SectionI.
are identicalto restrictions
The thirdconditionis therequirement thatanythirdpartyto thecontract
make nonnegativeprofits.The fourthand fifthconditionsare incentive
conditionson the firm.The fourthrequiresthatthe firmpreferbuying
theinformation and firingonlywhentheinformation is bad to notbuying
theinformation and alwaysfiring:
f(1)(h2- y2 - Z2) + [1 -f(1)](-yi - Zi) - m
f (1)(-y I- Z ) + [1 -f(1)](-yI - Z
which simplifiesto (5.4). Equation (5.5) is derivedanalogouslyfromthe

requirement thatthe firmprefersbuyingtheinformation and usingit to
not buyingit and alwaysretainingtheworker.
Finally,as in SectionI thereis a requirement that,giventheinformation,
the firmprefersto firein the low-productivity realizationand retainin
the high-productivity realization,but this requirementis subsumedby
conditions(5.4) and (5.5).
THEOREM 5.1. A quadruple(yi, Y2, z1, z2) is an optimal up-or-out
contractifand onlyifit satisfies(5.1)-(5.5),satisfyingconditions(5.1) and
(5.3) as equalities.
Define4 as z2 - z1 and rj asy2 - Y1and characterizeoptimalup-or-out
contractsmoresimplyas
h2 - >, +T >?hi + m
f() - f(O) '
and
Z1 = f),
yJ= V + i -f(1)ii.
In particular,
if
m
h2 - f~l <
m
hi + I -pi~)'
440 Kahn/Huberman
thenno up-or-outcontractcan be implemented.

If
m i
h2- ~~<
Mf() ff(1) -f(O)'
up-or-outcontractscan only be implementedwithnonzeropaymentsto

thirdparties.When such paymentsare needed,thenz1 is positiveand Z2
is negative:in otherwords,when a low paymentis made to the worker,
a paymentis also made to a thirdparty.
The profitsfroman up-or-outcontractare
f(1)h2 - v - i - m.
contractare
The profitsfroma full-employment
f(O)h2+ [1 -f(O)]h - v.
Thus, theup-or-outcontractdominateswhen
Z > [1 - f(1)](h, - r) + m,
where,as in SectionI, Z is thesocial gain fromtheemployeeinvestment.

Note thatthe only difference betweenthisconditionand (1.7) is the in-
clusionof thefirm'smonitoringcosts.
Inclusionof third-partypaymentspermitstheuse ofup-or-outcontracts
in a largervarietyof circumstances. In particular,forsufficientlysmall
valuesofm,up-or-outcontractsarealwaysfeasible.However,introduction
of third-party paymentsdoes not fundamentally changethenatureof the
up-or-outcontract.In particular, thewage is higherthantheopportunity
cost,and involuntary unemployment continuesto occur in the low pro-
ductivitystates.Similarly,the introductionof stochasticcontractswill
reduce,but not eliminate,theinvoluntary unemployment.
There is only one circumstancein which third-party paymentswill
eliminateinvoluntary unemployment: when the cost to firmsof the in-
formation on productivityis zero. In thiscase, a thirdformof contractis
feasibleand dominatesup-or-outcontracts.In thisthirdformof contract
theworkeralwaysworksforthefirm,and thetotalofthefirm'spayments
to the workerand thirdpartiesdoes not vary.If the workeris of high
productivity, he receivesmore of the total paymentsmade by the firm
thanif he is of low productivity. Since the firmis indifferent between
announcingthatthe workeris of a high or of a low productivity, it is
willingto makeits reportshonestly.
It is evidentthatthiscontractis a knife-edge formulation:ifthereis any
cost to obtainingthe information, no matterhow small that cost, this
"Up-or-Out"
Contracts 441
contractbecomesinfeasible and someunemployment is necessaryto obtain

honestreportingby thefirm.
The existenceof involuntary unemployment in up-or-outcontractsis
therefore robustto theintroductionof third-party
payments, providedwe
are willingto assumethatthefirmmustbear some cost in determining a
worker'sproductivity.
VI. Summary and Comparison with Other Work
In thisarticlewe haveused two-sideduncertainty to explainup-or-out

contracts.Up-or-outcontractsare a special case of involuntarylayoffs,
whicharein turna specialcase ofinvoluntary unemployment. The recent
literatureon optimalcontracting withinvoluntary unemployment is vo-
luminous;in thissectionwe will confineour attentionto thoseportions
mostcloselyrelatedto thiswork.
Theterm"involuntary unemployment" encompassesseveraloverlapping,
but conceptuallydistinct,notions.It may mean employmentat a level
lowerthanthatwhichwould occurunderfullinformation. It may mean
ex post regret.It may be a comparativeterm:theunemployedindividual
enviesan objectivelyidenticalindividualwitha job and associatedwage.
In our account,the layoffis involuntary in at least the firsttwo of these
senses.Layoffsonlyoccurbecauseoftheinformation imperfections. When
theydo occur,the individualobtainsless income. Moreover,he envies
anyonewhosedrawwas different and withwhomhe is objectively identical
forall periodsbeyondthecurrentone. The onlysensein whichthelayoff
is voluntaryis the ex ante sense:contractshave been efficiently arranged
at theoutset,relativeto theavailableinformation structure.
To obtaininvoluntary unemployment in a contracting model generally
requiresthe use eitherof privateinformation or some severerestrictions
on permitted contracts.A refereehas pointedout thatin our structure, if
both firmand workerobtainperfectinformation about the productivity
of the match,then it is always possible to use a contractto establisha
bargaininggame in whichit is a Nash equilibriumto splittheproductin
an arbitraryfashionas a functionof thematchproductivity. This remains
thecase evenifonlythetwo partiesto thebargainknow thematchvalue.
Giventhisflexibility,itis wastefulto use inefficientemployment decisions
as partof the incentivestructure in a contractin which both partiesare
fullyinformed.
Accountsofoptimalcontracting withone-sideduncertainty do nottend
to yieldinvoluntary layoffs.An exceptionis the accountby Stiglitzand
Weiss (1981),whichis a simpleversionof the multiperiodmoralhazard
model. However, to achieve the unemployment, these authorshave to
includean additionalassumptionlimitingthepenaltythatcan be charged
to the worker.Geanakoplos and Ito (1985) make layoffsinvoluntary by
442 Kahn/Huberman
havingthe firmunable to insurethe workercompletelybecause of its

inability
to monitorsubsequenteffort
expendedbyemployeeson job search.
The case of two-sideduncertaintyhas been extremelydifficult
to deal
within thecontractingframework (forexceptions,see Cooper [1981]and
Riordan[1984]).Sequentialmodelsoftheproblemhavebeenmorefruitful,
for example, Carmichael (1983), Malcomson (1984), and Ito and
Kahn (1985).8
Hahn (1984) (extendedby Mookherjee[1985])developsan involuntary
layoffmodel along thelinesof thesortingliterature. Individuals'produc-
tivityis graduallylearnedby the firmand only the most productiveare
retained.The involuntariness of the unemployment is due to the simul-
taneousneed to induceeffort.
Shapiro and Stiglitz(1984) develop a model thatis similarto ours in
severalrespects.In it,unemployment is involuntary. The threatof unem-
ploymentis used to ensurethatworkersexpend efforteven thoughthe
effort cannotbe contractedfordirectly.The firmshave the abilityto set
wages and some abilityto set levels of unemployment pay as well. The
model is multiperiod;in its basic formworkersare assumedriskneutral,
althoughan extensionexaminestherisk-averse case as well.
Butthesimilaritiesend at thispoint.The modeltheybuildis specifically
dependenton theinfinite-horizon assumption.If builtwitha finitehorizon
and time-consistent it unravelsbecausetheunderlying
strategies, structure
containsno specificcapitalinvestments. Even afterinvestment, actorsare
ex post identicalin thecurrentperiodas well as futureperiods;therefore,
futureperformance by thefirmis enforcedthroughpurethreatstrategies,
whichcan onlybe maintained throughtheexistenceofyetone moreperiod.
Threatsin our model are enforcedby availablerents.
The Shapiro-Stiglitzmodelcontainsinvoluntary unemployment butnot
involuntarylayoffs.Their unemployment resultsare due to an external
effectof one firmon the nextin contracting; therefore, the inefficiencies
in Shapiro-Stiglitz
do notdisappearasymptotically, as theydo in ourarticle.
If we wereto extendour modelto includetheexternaleffects, our results
would be analogous.Kahn and Mookherjee(1986) consideran extension
of thissort.
Thereis a potentialforgainthroughstochasticcontracts.In thecase of
riskaversion,stochasticcontractscan eliminatetheproductiveinefficien-
cies. For example,when the firmis riskneutral,it can achievethe same
outcomeby penaltiesin theformof stochasticpayments.By makingthe
expectationof thelotteryequal to thenonstochastic payoff,such a threat
8 Fora modelin whichmoralhazardandadverseselection

occuron thesame
side of the market,see Baron (1982). Eden (1985) uses lack of commitment
in a
similarway to our use of uncertainty.For a two-sidedmoralhazardmodel in the
literatureon industrialorganization,see Mann and Wissink(1984).
"Up-or-Out"
Contracts 443
can penalizetheemployeeforshirking withoutgivingtheemployer an

incentive to misrepresent andwithout thelossofproduction thatwould
otherwise be necessary. Thiscriticism affects
onlytheextension inSection
IV; inthecasewherebothparties areriskneutral,thegainsfrom stochastic
contracts do notqualitatively affectourresults.Thisbroader classofcon-
tractsis examined in KahnandMookherjee (1986).
In mostofthepaperwe haveassumedthatno thirdpartycan actas a
wedgebetween thepayments madebythefirm andthosereceived bythe
worker. Thisassumption is oftenjustifiedbya claimthat,iftheycould,
thetwopartiescouldcolludeto cheatthefinancing partyoutofthepay-
ment.Thisis a reasonable claimas longas thetwopartiesareassumed
betterinformed thananyoutsider wouldbe.However, thethirdpartycan
well be a fellowworker.As notedby Carmichael (1983),Bhattacharya
(1984),Malcomson (1984),andMookherjee (1985),inthepresence ofmul-
tipleemployees it maybe feasible to achievethefirst bestwithout firing
individuals.However,as we haveshownin SectionV, as longas thereis
somecostattached to thecollection of information therewillbe some
unemployment ex post, and the up-or-outstructurewill sometimesbe
optimal.We conjecture thatevenifsomeoftheinformation thefirmgathers
becomes known by the worker,unemployment will continueto occur,
provideda portionof theinformation thatthefirmobtainsdoes not pass
to theworker.
Our argument, as well as thoseof mostof thearticlescitedin theabove
literaturereview,assumesthatrenegotiations of contractsare too costly
to be relevant,eitherbecauseof directcostsor becauseof damageto rep-
utation.Elsewhere(Hubermanand Kahn 1988),we providea rationalefor
strategiccontractrenegotiations and studytheirimplications.
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NORC at the University of Chicago

The University of Chicago

Two-Sided Uncertainty and "Up-or-Out" Contracts

A bilateralmoral-hazardproblemprovidesa rationalefor "up-or-

In manyorganizations, ifpromotiondoes notoccurwithinsome settime,

We develop a simplecontracting frameworkthatprovidesa rationale

contingent on thedraw.However,we also assumethatbothh2and hi are

Z [f(1) -f(O)](h2 - hi) - i > 0. (1.1)

The quantityZ is thenetsocial gainyieldedby theinvestment.

(Ross 1973,Holmstrom1979).Full insurancebecomesimpossiblesinceit

f(1)y2 + [1 - f(l)]yi - i 2 f(O)y2 + [1 -f ()]yi. (1.2)

For theworkerto acceptthecontract,it is necessarythat

f(l)y2 + [1 -f(1)]yl - i 2 V. (1.3)

Together,thesetwo conditionstreatedas equalitiesdeterminelevelsof

It remainsto be determinedthatthe contractentailsa higherprofitthan

f(1)(h2- y2) + [1 - f(1)](h - yi) ? f (O)h2+ [1 -f(0)]h, - v. (1.5)

This conditionreducesto (1.1); providedtheinvestment

If we assumethatthird-partypayment is notpermitted as partofthe

f(1)y2 + [1 -f(1)]y, + r-i = vI

Y2 - Y1 2 i/[f (1) - f(0)].

i/[f(1) - f(O)] > h2, (1.6)

thenno up-or-outcontractcan be implemented.

Z > [1 - f(1 )](h - r). (1.7)

RememberthatZ is thesocial benefitof the investment underfullinfor-

II. The General 1-Period Model

Considerthefollowingrelationbetweena workerand a firm.The worker

forxl < X2, F(h Ixi) > F(hl X2), (2.1)

forall h in thesupportof F. Assumethesupportof F does notvary

P(w, k,x) = f (h - w)dF(hlx) - s. (2.2)

Given k, the probabilityof retentionis [1 - F(k Ix)]. Let the function

U(w, C,x) = (w - c)[1 - F(w Ix)] - ix + s, (2.4)

x E arg max U(w, c, x). (2.5)

LEMMA 2.1. The choice of x in (2.5) is nonincreasing

U(w, c2,x2)2 U(w, c2,xI),

U(wv,c, xI) 2 U(v C, x2).

Addingthe two inequalities,substituting

The conclusionfollowsfromtheapplicationof (2.1).

J(k,c, x) = f (h - c)dF(hlx) - ix, (2.6)

wherek is the employmentcutoffpoint.The level of employmentcom-

Definew * to be infinity if no w satisfies(2.8).2Note thatw * > c. Since

J(w*(x),c, x) <J(c, c, 0) forall x > 0. (2.9)

J(C,C,X) < J(C, C, 0). (2.10)

fwcfJ~ci(h-c)dF(hlx)-ix-f (h-c)dF(hIO) < 0. (2.11)

For eachx, theleftside is weaklydecreasingin i. Definei * as theinfimum

F(. I1) improvesor the distribution

III. A Multiperiod Extension

In thecasewhereX = {O,1}, a sufficient

Pr{h = Hjx} = 1-Nf-xB H =O

The employee'srisk of termination is not invariant;rather,it increases

In thenextsubsection(Sec. IIIA), we formulate and studythe2-period

J[hi - ri) + 6 (h2- r2)dF2(h2 Ilx)-ix.

Using the previoussection'sdefinitionsof 1-periodutilityU and joint

f (hi - k1)dFi(hI1x1)+ U(k1,ri - 3J2,x1), (3.1a)

From theprevioussectionswe can inferthatthefinalperiodchoicesare

42*= arg max U(w2,r2,x2). (3.3)

Note, therefore,that optimal x2 does not depend on w1. Let P2*(w2)

= argmax - w1 + P *(w2)]dF(h, w - P*(W2), (3.4)

x = argmax U(k , r1- 6J2, x1). (3.5)

The opportunity costto theworkerofstayingwiththefirmis no longer

2, r - aj**, x**) 2 U(k**, - a3** xl)

LEMMA 3.2. >

IV. Risk Aversion

In this sectionwe examinethe effectsof risk aversionon up-or-out

wherey is monetary compensation, andu is an increasing

= argmax - w1 + P (w2)]dF(h, w - P(W2), (3.4)

2, r - aj, x) 2 U(k, - a3 xl)