UNIT 6: OWNERS, MANAGERS AND EMPLOYEES

Index: Labor /Unemployment / Employment game / Incomplete contracts

1. Firms, markets, and the division of labor

A firm is a business organization which employs people, purchases inputs to produce market goods
and services and sets prices greater than the cost of production. There are asymmetric information
issues between different hierarchical levels. In the firm, several individuals interact:
➔ Owners decide on long-term strategy. The firm's profits legally belong to the owners’ of the
firm's assets.
➔ Managers implement their strategy to execute the vision of the owners. Managers’ actions
have key impacts on profits, but in general they will not benefit automatically from this.
➔ Workers are assigned tasks and monitored by managers.
The different goals of high charges in a company can create a conflict of interest, because managers,
particularly if they are on commission, may care more about revenue than other important things.
To solve this conflict of interest we can relate the managers’ pay to the performance of the company’s
share price or the owners can create mechanisms to monitor managers’ performance.

2. Employment
Hiring employees is very different from buying or renting other factors of production.
● Incomplete contracts:
○ Uncertainty about the future: employment contracts cannot predict all contingencies.
○ Measurement contracts issues: It is very costly to observe worker’s effort.
A truly enforceable contract, covering all aspects of the exchange between the parties, is impossible
to write. Also, even if workers like their job, effort brings a disutility.

3. Effort
Observing effort is difficult, but we can measure output, assuming output is positively correlated with
effort. We can incentivize effort by providing compensation based on output: piece rates (wage rate
depending on units of output produced).
Firms can also provide other types of incentives to boost effort:
● Provide fringe benefits (health insurance, childcare, gym, etc.)
● Ensure promotion opportunities (based on performance)
● Offer adequate working conditions
● Promote life-work balance and be flexible if possible (remote working, flexible schedules,
etc.)
● Trust workers with additional responsibilities.
At the same time, workers have intrinsic motivations to exert effort:
● Work ethic
● Feelings of responsibility
● Reciprocity for good working conditions
● Fear of being fired

4. Employment rent
Employees fear getting fired when they are paid more than their reservation option.
➔ Employment rent=reservation wage-disutility of effort.
The employment rent is the cost of losing a job, and this cost may include:
 ● Lost income while searching for a job
● Costs required to start a new job (relocation, acquiring new skills, etc.)
● Loss of non-wage benefits
● Social costs (stigma of being unemployed)
Reservation wage: is the amount of money that makes workers indifferent between working or not. Is
the value of the next best option which can be other employment or unemployment benefits.
❖ WITHOUT BENEFITS:
Maria’s employment rent for a
given level of effort if she gets
a $12 wage/hour (35h week),
with an expected duration of
unemployment of 44 weeks.
All of these supposing she is in
an economy with NO
unemployment benefits.
If Maria gets fired and she has
to wake up all the mornings
one hour earlier to go to her
job, she no longer has that
disutility in her job.
Employment rent/hour=
=wage – disutility of effort =$12-$2=$10
Total Employment rent= =$10 x 1540=$15540

❖ In an economy WITH
unemployment benefits:
If the people have a
mattress when they are
fired, there is more
possibility that Maria
does not put that effort
into her work because she
will receive a government
subsidy without the
necessity of putting any
effort.

Employment rent = =wage – reservation wage – disutility of effort =$12-$6-$2=$4<$10

Total Employment rent= =$4 x 1540=$6160

5. Employment game/labor discipline model

Analysis of the employment rent: Large employment rent is associated to a large cost of job loss and,
so there will be a higher effort from the worker.
Firms may also induce more effort from workers by increasing wages, and this will increase the
unemployment rent.
The employment game/labor discipline model: workers represent the supply (they are willing to sell
labor) and firms represent the demand (they are willing to buy labor).
● Employer chooses a wage, if the worker works hard enough, keeps the job at the offered wage
 ● Worker chooses the level of effort, considering the costs of losing the job if effort is too low.
Payoffs:
Employers: worker output – wages
Workers: employment rent

5.1. Worker’s side

Maria’s feasible set of choices (from the example on the
previous slides) are represented in the FF:
● Feasible wages are those above reservation
wage: the worker prefers not to work below the
reservation wage.
● Points inside the feasible set are not efficient
● Worker is exerting low effort for the wage, and
can lose the job
● Points at the boundary are efficient/non wasteful
options (the best response curve)
● The slope of this best response is the MRT.

5.2. Firm’s side

Firms want to maximize profits.

Employers should find a feasible combination of effort and wages that minimize the cost per unit of
effort. Trade-off between wages and effort:
● Wages=cost
● But they are also associated with effort levels that affect output produced and revenue.
➔ Combinations of effort and wages that cost the same are represented in Iso-cost lines.
➔ More vertical lines are combinations with a lower cost § [you get more effort from lower
wage]
➔ Slope=MRS (The employer is willing to increase wages to get higher effort).

5.3. Equilibrium
● Profits are maximized at:
○ The steepest iso-cost line,
where the cost is lower
○ Subject to worker’s best
response curve [maximal
effort per wage level]
● MRS=MRT [tangency of
iso-cost/best response]. In our
example, $12/hour represents the
equilibrium wage
● Equilibrium wage: less costly
option to guarantee maximum
effort.
 5.4. Involuntary unemployment
Involuntary unemployment: being out of work, but preferring to have a job, given the wages/working
conditions that identical employed workers have
If Maria gets fired and the next day she gets a job, she will not have any compromise with her current
company, there would be no fear of unemployment.
So, there would be zero effort and nobody would work and we would never reach an equilibrium
situation, because an employer will not pay someone that does not work.
In equilibrium, both wages and involuntary unemployment have to be high enough to ensure
employment rent is high enough for workers to put in the effort.

5.5. Changes in
equilibrium
The equilibrium depends crucially
on the relation between wages and
effort (best response of the
worker).
The best response (and the
equilibrium) may change in
reaction to changes in:
● Utility of things that the
wage can buy
● Disutility of effort
● Reservation wage
● Probability of getting
fired at each effort level.

6. Incomplete Contracts
Incomplete contracts do not occur only in employment relationships, but they arise when:
● Information is not verifiable
● Relationships cover a period of time
● Uncertainty
● Difficulties in measurement
● Judiciary enforcement is not available or very hard.
● Preferences for omitting some information.
Agency relation: Any relation where someone (principle) appoints another person (agent) to act on
their behalf, with possibly conflicting self-interests. With incomplete contracts, agents’ action is not
(fully) observable – hidden action problem.

Principal-agent models describe interactions of parties under incomplete contracts.

● Employment contracts: manager (principal) / workers (agent)

● Investments: investors (principal) / fund managers (agent)
● Elections: citizens (principal) / politicians (agent)