This paper considers a firm whose marginal (revenue) product of labor is a random variable. We derive the form of an optimal long-term contract between workers and the firm under the assumption that labor's marginal product is observed by the firm but not by the workers. We show that the existence of asymmetric information causes unemployment to be greater than in a situation where information about labor's marginal product is public, or where employment is determined in spot markets. In particular, unemployment can occur when the marginal product of labor exceeds the reservation wage.

Most analyses of the principal-agent problem assume that the principal chooses an incentive scheme to maximize expected utility subject to the agent's utility being at a stationary point.An important paper of Mirrlees has shown that this approach is generally invalid.We present an alternative procedure.If the agent's preferences over income lotteries are independent of action, we show that the optimal way of implementing an action by the agent can be found by solving a convex programming problem.We use this to characterize the optimal incentive scheme and to analyze the determinants of the seriousness of an incentive problem.'Support from the U.K.

[In an economy with incomplete markets, firms' profits at different dates and contingencies cannot be aggregated into a single index and so profit maximization is not well-defined. In this paper we propose an objective for firms to pursue which is a generalization of the idea of profit maximization. We show that, if firms' managers can transfer current income between shareholders at the first date, and if shareholders have what we call competitive perceptions concerning the effect of a change in production plan on share prices, then each firm will maximize a weighted sum of shareholders' private valuations of the firm's production plan, where the weights are the initial shareholdings. We then define, and prove the existence of, a competitive equilibrium in which firms pursue this proposed objective. Finally, we analyze the optimality properties of the competitive equilibrium.]

A general equilibrium model of optimal employment contracts is developed where firms have better information about labor's marginal product than workers. It is optimal for the wage to be tied to the level of employment, to prevent the firm from falsely stating that the marginal product is low and cutting the wage. It is shown that an observed aggregate shock that leads to an interindustry shift in labor demand and that would have no effect on total employment under symmetric information leads to a reduction in employment when firms and workers have asymmetric information.

Our theory of costly contracts emphasizes that contractual rights can be of two types: specific rights and residual rights. When it is costly to list all specific rights over assets in the contract, it may be optimal to let one party purchase all residual rights. Ownership is the purchase of these residual rights. When residual rights are purchased by one party, they are lost by a second party, and this inevitably creates distortions. Firm 1 purchases firm 2 when firm 1's control increases the productivity of its management more than the loss of control decreases the productivity of firm 2's management.

A general equilibrium model of optimal employment contracts is developed where firms have better information about labor's marginal product than workers. It is optimal for the wage to be tied to the level of employment, to prevent the firm from falsely stating that the marginal product is low and cutting the wage. It is shown that an observed aggregate shock that leads to an interindustry shift in labor demand and that would have no effect on total employment under symmetric information leads to a reduction in employment when firms and workers have asymmetric information.

It is sometimes asserted that rational speculative activity must result in more stable prices because speculators buy when prices are low and sell when they are high. This is incorrect. Speculators buy when the chances of price appreciation are high, selling when the chances are low. Speculative activity in an economy in which all agents are rational, have identical priors, and have access to identical information may destabilize prices, under any reasonable definition of destabilization. It takes extremely strong conditions to ensure that speculative activity (of the commodity storage variety) "stabilizes" price, even in a very weak sense.