Implicit Contracts in the Absence of Enforcement: Note
In recent years, implicit theory has grown following by Martin Baily (1974) and Costas Azariadis (1975). A major concern in much of this literature has been problem of enforceability of implicit contracts. The problem is that for any to trade labor services, or some other good at some future time t, there will always be motivation for one of contracting parties to breach whenever future spot price at t deviates from contractual price. In absence of some formal enforcement mechanism (i.e., courts), or informal mechanism (such as concern for reputation or front-end loading), contracts would never be fulfilled. In an important contribution to this literature, Clive Bull (1983) proposed a model under which implicit contracts would become partially enforceable due to what might be called a package contract for two distinct labor services, which he called labor and Bull argued that inability to trade effort separately due to nonexistence of a market for such would lead to implicit contracts that were partially enforceable (i.e., in at least some states of world). His conclusion was that the very aspect of economy that gives rise to implicit contracts [is]. ... absence of a complete set of (p. 668). It is theme of this note that absence of markets for some aspects of labor is unnecessary in order to achieve Bull results of partial enforceability. While such enforceability is possible when some labor markets are missing, it is no less possible when labor markets are complete (although contingent claims markets must remain incomplete). To see this, let us follow Bull and imagine that a worker is supplying two distinct labor services, which will be called work and effort. Each of these may be marketed separately to different purchasers, or two may be marketed jointly in a multiple contract.1 Now future prices of (or Xt) and of effort (or Y,) are unknown before t, and no contingent claims or enforceable forward markets for them exist. In absence of formal legal enforcement or informal enforcement (such as concern for reputation), no for supplying either labor service separately would be fulfilled. A to supply at price Xt would be broken by workers as soon as future spot price rose above that, and would be breached by employers as soon as it fell below Xt. The same would hold for separate contracts to purchase But what about joint or multiple contracts to supply both and effort simultaneously? Let indirect utility function of worker be i3tU(Xt, Yt), where Pt is discount factor for future period t. Let indirect utility function of employer or purchaser be /3tW(Xt, Yt). For both U and W functions, first partials with respect to both arguments are positive and second partials are negative. Both U and W are continuous, differentiable functions and Inada conditions hold. Let us assume there is a to jointly trade and effort at promised prices of