When fewer goods are produced workers are laid off credit becomes difficult to obtain?

Diego Rivera’s Production of Automobile mural at the Detroit Institute of Arts

How the interactions among the firm’s owners, managers, and employees influence wages, work, and profits, and how this affects the entire economy

• The firm is an actor in the capitalist economy, and a stage on which interactions among the firm’s employees, managers, and owners are played out.
• Hiring labour is different from buying other goods and services, and the contract between the employer and the employee is incomplete. It does not cover what the employer really cares about, which is how hard and well the employee works.
• Incomplete contracts arise when important information, such as the employee’s effort, is asymmetric or non-verifiable.
• In economics, employment is modelled as a principal (the employer) interacting with an agent (the employee).
• The principal–agent model can be used to study other relationships with incomplete contracts, such as the interaction between a lender and a borrower.
• Firms do not pay the lowest wages possible. They set wages so that employees earn economic rents, to motivate them to work effectively, and stay with the firm.
• Working together in firms brings mutual gains: profit for owners, and economic rents for managers and employees. But rents also lead to involuntary unemployment in the economy.

Apple’s iPhone and iPad are iconic American hi-tech products, yet neither is assembled in the US. Until 2011 a single company, Foxconn, produced every iPhone and iPad in factories in China, mainly so that Apple could take advantage of lower costs, including wages.

The components of the iPhone and iPad for the most part do not come from China, but are sourced from around the world. Components such as the flash memory, display module, and touch screen are made by a number of different companies including Toshiba and Sharp in Japan. The microprocessor is made by Samsung in South Korea and other components, by Infineon in Germany. Like other firms, Apple makes profits by finding the supplier that can provide inputs at the lowest cost, whether the input is a component or labour, wherever in the world that supplier may be located.

The cost of assembling the components into the final product in China is small—making up only 4% of the total cost—compared to the cost of components sourced from high-wage economies such as Germany and Japan. Almost half of Apple’s employees in the US sell Apple products rather than making them, while firms compete on a global scale to win the lucrative business of supplying Apple with its components. The cost of producing the iPhone is far lower than the price Apple charges: in 2016, a 32Gb iPhone 7 cost $224.80 to manufacture. Its price in the US was $649.

Apple is not alone in outsourcing (or offshoring) production to countries that are not the main market for the goods produced. In most manufacturing industries, firms based in rich countries have transferred a significant proportion of production, which was previously done by local employees, to poorer countries where wages are lower. But Apple and other firms are looking for more than cheap labour. Wages in some of Apple’s source countries such as Germany are higher than in the US.

Other industries, particularly garment manufacturing, have relocated primarily to low-wage economies. More than 97% of apparel and 98% of footwear sold in the US by American brands and retailers is made overseas. China, Bangladesh, Cambodia, Indonesia, and Vietnam are now among the world’s main exporters of textiles and clothing. At the time of the Industrial Revolution, the world’s largest exporter was Britain.

Also, in developing countries, additional business costs such as health and safety rules are far lower, and environmental regulations are often less strict.

Apple, Samsung, and Toshiba are business organizations called firms. Not everyone is employed in a firm. For example, many farmers, carpenters, software developers or personal trainers work independently, as neither employee nor employer. While some people work for governments and not-for-profit organizations, the majority of people in rich nations make their living by working in a firm.

Firms are major actors in the economy and we will use this and the next unit to explain how they work. A firm is often referred to as if it were a person: we talk about ‘the price Apple charges’.

But while firms are actors—and in some legal systems are treated as if they were individuals—firms are also the stage on which the people who make up the firm (employees, managers, and owners) act out their sometimes common but sometimes competing interests. In our ‘Economist in action’ video Richard Freeman, an economist who specializes in labour markets, explains some of the consequences of outsourcing for these actors.

To understand the firm, we will model how employers set wages and employees respond. We have already seen, in earlier units, the importance of work, and firms, in the economy:

• Work is how people produce their livelihoods. In deciding how much time to spend working, people face a trade-off between free time and the goods that they can produce, or the wage income that they can earn.
• Production, wages, and living standards have grown through the innovation and adoption of new technologies by firms.
• If a production process requires labour to be combined with other inputs—like Angela’s labour and Bruno’s land—then a voluntary contract between the owners of those inputs can determine how the surplus from their interaction will be shared between the two parties, depending on their bargaining power.
• There are potential gains (to all concerned) from individuals specializing in tasks for which they have a comparative advantage.
• The division of labour may be coordinated through market exchange. In Unit 1, specialization in grain and apples was coordinated through buying and selling grain and apples. In Unit 5, the interaction between Angela and Bruno was coordinated by a contract trading the use of land for a share of the crop.
• Sometimes, however, people need to work together to produce something that will benefit all of them, and their success will depend on their preferences and strategies to discourage free riding.
• Another way that work may be coordinated and combined with other inputs is by organization within a firm. The firms in Unit 2 produced cloth, deciding how much coal to buy and how many workers to employ.

We illustrated each of these conclusions using models that illuminate some aspects of the economy, while setting aside others. In Unit 2, we did not consider how the length of the working day was determined while the economy was growing. In Unit 3, we did not model how the wage or the marginal rate of transformation of free time into goods was determined when we analysed a decision on working hours. In Unit 2 we told a story of conflicting interests over wages, but we did not model strategic interaction and bargaining until Units 4 and 5. And in Unit 5 we used the story of just two (imaginary) people called Bruno and Angela to model how bargaining may affect the Pareto efficiency and fairness of allocations.

In this unit, we study how, in the modern capitalist economy, the coordination of labour takes place within firms. We model how wages are determined when there are conflicts of interest between employers and employees, and look at what this means for the sharing of the mutual gains that arise from cooperation in a firm.

In Unit 7, we look at the firm as an actor in its relationship with other firms and with its customers.

6.1 Firms, markets, and the division of labour

The economy is made up of people doing different things, for example producing Apple display modules or making clothing for export. Producing display modules also involves many distinct tasks, done by different employees within Toshiba or Sharp, the companies that make them for Apple.

Setting aside the work done in families, in a capitalist economy, the division of labour is coordinated in two major ways: firms and markets.

Among the institutions of modern capitalist economies, the firm rivals the government in importance. John Micklethwait and Adrian Wooldridge explain how this happened. John Micklethwait and Adrian Wooldridge. 2003. The Company: A Short History of a Revolutionary Idea. New York, NY: Modern Library.

Why do firms work the way they do? For example, why do the owners of the firm hire the workers, rather than the other way around? Randall Kroszner and Louis Putterman summarize this field of economics. Randall S. Kroszner and Louis Putterman (editors). 2009. The Economic Nature of the Firm: A Reader. Cambridge: Cambridge University Press.

• Through firms, the components of goods are produced by different people in different departments of the firm, and assembled to produce the finished shirt or iPhone.
• Or components produced by groups of workers in different firms may be brought together through market interactions between firms.
• By buying and selling goods on markets, the finished iPhone gets from the producer into the pocket of the consumer, and the American Apparel shirt ends up on somebody’s back.

So in this unit we study firms. In the units to follow, we study markets. Herbert Simon, an economist, used the view from Mars to explain why it is important to study both.

Imagine a visitor approaching Earth from Mars, Herbert ‘Herb’ Simon (1916–2001) urged his readers. Looking at Earth through a telescope that revealed social structure, what would our visitor see? Companies might appear as green fields, he suggested, divisions and departments as faint contours within. Connecting these fields, red lines of buying and selling. Within these fields, blue lines of authority, connecting boss and employee, foreman and assembly-worker, mentor and mentee.

Traditionally, economists had focused on the market and the competitive setting of prices. But to a visitor from Mars, Simon suggested:

Organizations would be the dominant feature of the landscape. A message sent back home, describing the scene, would speak of ‘large green areas interconnected by red lines.’ It would not likely speak of ‘a network of red lines connecting green spots’. (‘Organizations and Markets’, 1991)1

Trained as a political scientist, Simon’s desire to understand society led him to study both institutions and the human mind—to open the ‘black box’ of motivations that economists had come to take for granted. He was celebrated in departments of computer science, psychology, and, of course, economics, for which he won the Nobel Prize in 1978.

A firm, he pointed out, is not simply an agent, shifting to match supply and demand. It is composed of individuals, whose needs and desires might conflict. In what ways could these differences be resolved? Simon asked, when would an individual shift from contract work (a ‘sale’ of a particular, predefined task) to an employment relation (where a boss dictates the task after the sale—the relationship at the heart of a firm)?

When the desired task is easy to specify in a contract, Simon explained that we could view this as simply work-for-hire. But high uncertainty (the employer not knowing in advance what needs to be done) would make it impossible to specify in a contract what the worker was to do and, in this case, the result would be an employer-employee relation that is characteristic of the firm.2

This early work showcased two of Simon’s lasting interests: the complexity of economic relations, where one might sell an obligation that was incompletely described, and the role of uncertainty in changing the nature of decision making. His argument demonstrated the emergence of the ‘boss’.

Understanding how contract work turns into employment only implies that we understand a particular relationship between two members of an organization. We have yet to explain the firm as a whole—the Martian’s green fields.

What makes a good organization? This is a question for psychologists as much as economists, because we know that incentives that tie individual rewards to the success of the organization appear to have little effect.

Simon’s intellectual career can be contrasted with another great economist, Friedrich Hayek, whose ideas we will examine in detail in Unit 11. Both were interested in how societies could thrive in the face of uncertainty and imperfect agents. For Hayek, the price mechanism was all: a device to collect and process vast quantities of information, and so synchronize systems of arbitrary size.

But for Simon, the price mechanism needed to be supplemented—even supplanted—by institutions and governments better equipped to handle uncertainty and rapid change. These alternative ‘authority mechanisms’ draw on partially understood aspects of the human psyche: loyalty, group identification, and creative satisfaction.

By the time of his death in 2001, Simon had seen many of his ideas reach the mainstream. Behavioural economics has roots in his attempts to build economic theories that reflect empirical data. Simon’s view from Mars shows that economics could not be a self-contained science: an economist needs to be both a mathematician, working with decision-sets and utilities, and a social psychologist, reasoning about the motivations of human relationships.

The coordination of work

The way that labour is coordinated within firms is different to coordination through markets:

• Firms represent a concentration of economic power: This is placed in the hands of the owners and managers, who regularly issue directives with the expectation that their employees will carry them out. An ‘order’ in the firm is a command.
• Markets are characterized by a decentralization of power: Purchases and sales result from the buyers’ and sellers’ autonomous decision. An ‘order’ in a market is a request for a purchase that can be rejected if the seller pleases.

The prices that motivate and constrain people’s actions in a market are the result of the actions of thousands or millions of individuals, not a decision by someone in authority. The idea of private property specifically limits the things a government or anyone else can do with your possessions.

In a firm, by contrast, owners or their managers direct the activities of their employees, who may number in the thousands or even millions. The managers of Walmart, the world’s largest retailer, decide on the activities of 2.2 million employees, a larger number of people than any army in world history before the nineteenth century. Walmart is an exceptionally large firm, but it is not exceptional in that it brings together a large number of people who work together in a way coordinated (by the management) to make profits.

Unlike flash mobs, firms do not form spontaneously and then disappear. Like any organization, firms have a decision-making process and ways of imposing their decisions on the people in it. When we say that ‘Apple outsourced its component production’ or ‘the firm sets a price of $10.75’, we mean that the decision-making process in the firm resulted in these actions.3

Figure 6.1 shows a simplified picture of the firm’s actors and decision-making structure.

Born in Prussia (now part of Germany), he attended the local classical high school, which was celebrated for its ethos of enlightened liberalism. In 1842 he became a writer and editor for the Rheinische Zeitung, a liberal newspaper, which was then closed by the government, after which he moved to Paris and met Friedrich Engels, with whom he collaborated in writing The Communist Manifesto (1848). Marx then moved to London in 1849. At first, Marx and his wife Jenny lived in poverty. He earned money by writing about political events in Europe for the New York Tribune.

Marx saw capitalism as just the latest in a succession of economic arrangements in which people have lived since prehistory. Inequality was not unique to capitalism, he observed—slavery, feudalism, and most other economic systems had shared this feature—but capitalism also generated perpetual change and growth in output.6

He was the first economist to understand why the capitalist economy was the most dynamic in human history. Perpetual change arose, Marx observed, because capitalists could survive only by introducing new technologies and products, finding ways of lowering costs, and by reinvesting their profits into businesses that would perpetually grow.

This, he claimed, inevitably caused conflict between employers and workers. Buying and selling goods in an open market is a transaction between equals: nobody is in a position to order anyone else to buy or sell. In the labour market, in which owners of capital are buyers and workers are the sellers, the appearance of freedom and equality was, to Marx, an illusion.

Employers did not buy the employee’s work, because this cannot be purchased, as we have seen in this unit. Instead, the wage allowed the employer to rent the worker and to command workers inside the firm. Workers were not inclined to disobey because they might lose their jobs and join the ‘reserve army’ of the unemployed (the phrase that Marx used in his 1867 work, Capital). Marx thought that the power wielded by employers over workers was a core defect of capitalism.7

Capital is long and covers many subjects, but you can use a searchable archive to find the passages you need.

Marx also had influential views on history, politics, and sociology. He thought that history was decisively shaped by the interactions between scarcity, technological progress, and economic institutions, and that political conflicts arose from conflicts about the distribution of income and the organization of these institutions. He thought that capitalism, by organizing production and allocation in anonymous markets, created atomized individuals instead of integrated communities.

In recent years, economists have returned to themes in Marx’s work to help explain economic crises. These themes include the firm as an arena of conflict and of the exercise of power (this unit), the role of technological progress (Unit 1 and Unit 2), and the problems created by inequality (Unit 19).

Why is it not possible for firms just to pay employees according to how productive they are? For example, paying employees at a clothing factory $2 for each garment they finish. This method of payment, known as piece rate, provides the employee with an incentive to exert effort, because employees take home more pay if they make more garments.

In the late nineteenth century the pay of more than half of US manufacturing workers was based on their output, but piece rates are not widely used in modern economies. At the turn of the twenty-first century less than 5% of manufacturing workers in the US were paid piece rates and, beyond the manufacturing sector, piece rates are used even less often.8

Why do most of today’s firms not use this simple method to induce high effort from their employees?

• It is very difficult to measure the amount of output an employee is producing in modern knowledge- and service-based economies (think about an office worker, or someone providing home care for an elderly person).
• Employees rarely work alone, so measuring the contribution of individual workers is difficult (think about a team in a marketing company working on an advertising campaign, or the kitchen staff at a restaurant).

If piece rates are not practical, then what other method could a firm use to induce high effort from workers? How could the firm provide an incentive to do the job well, even though the worker is paid for time and not output? Just as the owners of the firm protect their interests by linking management pay to the firm’s share price, the manager uses incentives so that employees will work effectively.

Which of the following are reasons why employment contracts are incomplete?

• The firm cannot contract an employee not to leave.
• The firm cannot specify every eventuality in a contract.
• The firm is unable to observe exactly how an employee is fulfilling the contract.
• The contract is unfinished.

• It may be costly for the firm if the employee leaves, but employees retain the right to do so.
• Since the firm does not know all the tasks it will require of an employee, the contract is necessarily incomplete.
• Since effort or the quality of an individual’s work cannot be perfectly monitored and measured, it cannot be specified in the contract.
• Employment contracts are usually long-term. An incomplete contract is not one that is unfinished, but rather one that does not completely specify every relevant aspect of the relationship.

6.4 Employment rents

There are many reasons why people put in a good day’s work. For many people, doing a good job is its own reward, and doing anything else would contradict their work ethic. Even for those not intrinsically motivated to work hard, feelings of responsibility for other employees or for one’s employer may provide strong work motivation.

For some employees, hard work is a way to reciprocate a feeling of gratitude to the employer for providing a job with good working conditions. In other cases, firms identify teams of workers whose output is readily measured—for example, the percentage of on-time departures for airline staff—and pay a benefit to the whole group that is divided among team members.

But in the background, there is another reason to do a good job: the fear of being fired, or of missing the opportunity to be promoted into a position that has higher pay and greater job security.

Laws and practices concerning the termination of employment for cause (that is, because of inadequate or low quality work, not due to insufficient demand for the firm’s product) differ among countries. In some countries, the owners of the firm have the right to fire a worker whenever they choose, while in others, dismissal is difficult and costly. But even in these cases, an employee has to fear the consequences of not working up to the employer’s desired standards. Such a worker, for example, would be unlikely to achieve a position in the firm where she could count on remaining employed when lower demand for the firm’s products results in other workers being dismissed.

Do workers care whether they lose their jobs?

If firms paid their employees the lowest wages they would be willing to accept, the answer would be no. Such a wage would make the worker indifferent between remaining in the job and losing it. But in practice most workers care very much. There is a difference between the value of the job (taking into account all the benefits and costs it entails) and the value of the next best option—which is being unemployed and having to search for a new job. In other words, there is an employment rent.

Employment rents can benefit owners and managers in two ways:

• The employee is more likely to stay with the firm: If she were to quit the job, the firm would need to pay to recruit and train someone else.
• They can threaten to fire the worker: Owners and managers exert power over employees because the employee has something to lose. The threat can be implicit or explicit, but it will make the worker perform in ways that she would not choose unless this was the case.

We can use the same reasoning in the employment of managers by the owners of the firm. The main reason owners wield power over managers is that they can fire them, and so eliminate their managerial employment rents.

These examples show the effect of the power that managers and owners exert.

• Labour economists Alan Krueger and Alexandre Mas unravel the mystery of why the tread on Bridgestone (Firestone) tyres was separating, endangering motorists and reducing profits.9
• Barbara Ehrenreich worked undercover for minimum wage in motels and restaurants to see how America’s poor live.10
• Polly Toynbee, a British journalist, had previously done the same in the UK in 2003, taking jobs such as call centre employee and care home worker.11
• Harry Braverman provides a history of what he calls the ‘deskilling’ process, and suggests how dumbing down jobs is a strategy for maximizing the employer’s profits.12

The writer George Bernard Shaw (1856–1950) joked that ‘if all economists were laid end to end, they would not reach a conclusion.’

This is funny, but not entirely true.

For example, the two leading economists of the early nineteenth century—Ricardo and Malthus—were political opponents. Ricardo often sided with businesspeople, for example in supporting freer imports of grain to Britain to reduce food prices and allow lower wages. Malthus opposed him and supported the Corn Laws that restricted grain imports, a position favoured by the landed gentry. But the two economists both proposed the same theory of land rents, which we still use today.

Even more striking is that two economists from different centuries and political orientations came up with similar ways of understanding the firm and its employees.

In the nineteenth century, Marx contrasted the way that buyers and sellers interact on a market, voluntarily engaging in trade, with how the firm is organized as a top–down structure, one in which employers issue orders and workers follow them. He called markets ‘a very Eden of the innate rights of man’, but described firms as ‘exploit[ing] labour-power to the greatest possible extent.’

When Ronald Coase died in 2013, he was described by Forbes magazine as ‘the greatest of the many great University of Chicago economists’. The motto of Forbes is ‘The capitalist tool’, and the University of Chicago has a reputation as the centre of conservative economic thinking.

Yet, like Marx, Coase stressed the central role of authority in the firm’s contractual relations:

Note the character of the contract into which an [employee] enters that is employed within a firm … for certain remuneration [the employee] agrees to obey the directions of the entrepreneur. (The nature of the firm, 1937)

Recall that Coase had also defined the firm by its political structure: ‘If a workman moves from department Y to department X, he does not go because of a change in prices but because he is ordered to do so.’ He sought to understand why firms exist at all, quoting his contemporary D. H. Robertson’s description of them as ‘islands of conscious power in this ocean of unconscious cooperation’.

Both based their thinking on careful empirical observation, and they arrived at a similar understanding of the hierarchy of the firm. They disagreed, however, on the consequences of what they observed: Coase thought that the hierarchy of the firm was a cost-reducing way to do business. Marx thought that the coercive authority of the boss over the worker limited the employee’s freedom. Like Malthus and Ricardo, Coase and Marx disagreed. But like Malthus and Ricardo, they also advanced economics with a common idea.

Counting the cost of job loss

Recall that an economic rent measures the value of a situation—for example, having your current job—compared to what you would get if the current situation were no longer possible.

To calculate employment rent—or in other words, the net cost of job loss—we need to weigh up all the benefits and costs of working compared with being unemployed and searching for another job.

There are some costs of working, such as:

• The disutility of work: Employees must spend time doing things they would prefer not to do.
• The cost of travelling to work every day.

But there are many benefits, which would be lost if you lost your job:

• Wage income: This may be partially offset by an unemployment benefit or, in poorer countries, by the possibility of lower-paying self-employment or work on the family farm.
• Firm-specific assets: These include workplace friends, and perhaps the proximity of the workplace to your present home.
• Medical insurance: The employer may pay for the employee’s healthcare in some countries.
• The social status of being employed: In Unit 13 we will see that the stigma of being unemployed is equivalent to a substantial financial cost for most people.

Even confining attention to the loss in wages, the cost is high. But how do we measure how high it is?

Setting aside the undoubtedly large but hard-to-measure psychological and social cost of losing one’s job, estimating the cost of job loss (the size of the employment rent) is not simple.

Can we compare the economic situation of workers currently employed with the economic situation of unemployed people? No, because the unemployed are a different group of people, with different abilities and skills. Even if they were employed, they would be likely (on average) to earn less than people who currently have jobs.

natural experimentAn empirical study exploiting naturally occurring statistical controls in which researchers do not have the ability to assign participants to treatment and control groups, as is the case in conventional experiments. Instead, differences in law, policy, weather, or other events can offer the opportunity to analyse populations as if they had been part of an experiment. The validity of such studies depends on the premise that the assignment of subjects to the naturally occurring treatment and control groups can be plausibly argued to be random.

An entire firm closing, or a mass layoff of workers, provides a natural experiment that can help. We could look at the earnings of workers before and after they lost their job during a major employment cutback. When a factory closes because the parent company has decided to relocate production to some other part of the world, for example, virtually all workers lose their jobs, and not just the ones who were most likely to lose their jobs through poor performance.13 14

Louis Jacobson, Robert Lalonde, and Daniel Sullivan used such a natural experiment to estimate the cost of job loss. They studied experienced (not recently hired) full-time workers hit by mass layoffs in the US state of Pennsylvania in 1982. In 2014 dollars, those displaced had been averaging $50,000 in earnings in 1979. Those who were fortunate enough to find another job in less than three months took jobs that paid a lot less, averaging only $35,000: being laid off meant that their earnings declined by $15,000.15

Four years later they were still making $13,300 less than similar workers who had been making the same initial wage, but whose firms did not lay off their workers. In the five years that followed their layoff they lost the equivalent of an entire year’s earnings.

Many, of course, did not find work at all. They suffered even greater costs.

The year 1982 was not a good time to be looking for work in Pennsylvania, but similar estimates (from the US state of Connecticut between 1993 and 2004 for example) suggest that even in better times, employment rents are large enough that workers would worry about losing them.

In which of the following employment situations would the employment rent be high, ceteris paribus?

• In a job that provides many benefits, such as housing and medical insurance.
• In an economic boom, when the ratio of job-seekers to vacancies is low.
• When the worker is paid a high salary because she is a qualified accountant and there is a shortage of accountancy skills.
• When the worker is paid a high salary because the firm’s customers know and trust her.

• If the employee loses the job, all these benefits would be lost, so the economic rent from employment is high.
• The cost of job loss is low, because it would be easy to find another job. Therefore, the economic rent is low.
• A qualified accountant will be able to find other jobs easily at a similar salary, so the economic rent is low.
• This worker is paid a high salary because of firm-specific assets that will be lost if she leaves. Other firms would pay a lower salary (at least initially) so the economic rent is high.

6.5 Determinants of the employment rent

To construct a model of how employment rents may be used to motivate employees to work hard, we consider Maria, an employee earning $12 an hour for a 35-hour working week. To determine her economic rent, we need to think how she would evaluate two aspects of her job:

• The pay that she gets: which is something she values.
• How hard she works: she would like to do no more work than is necessary.

Using the concept of utility introduced in Unit 3, we can say that Maria’s utility is increased by the goods and services she can buy with her wage, but reduced by the unpleasantness of going to work and working hard all day—the disutility of work.

Her disutility of work depends on how much effort she puts into her job. Suppose she spends half of her working time actually working, and half doing other things like checking Facebook. We represent this as an effort level of 0.5. Working this hard is equivalent to a cost of $2 per hour to Maria. To calculate her employment rent we first find her net utility of working and earning $12, compared with being unemployed and earning nothing:

This is her employment rent per hour. The total employment rent (or cost of job loss), depends on how long she expects to remain unemployed. We will suppose that if she loses her job she can expect to remain unemployed for 44 weeks before finding another. The analysis in Figure 6.2 shows how to calculate the rent.

Mill thought that the structure of the typical firm was an affront to freedom and individual autonomy. In The Principles of Political Economy (1848), Mill described the relationship between firm owners and workers as an unnatural one: ‘To work at the bidding and for the profit of another, without any interest in the work … is not, even when wages are high, a satisfactory state to human beings of educated intelligence,’ he wrote.20 21

Attributing the conventional employer-employee relationship to the poor education of the working class, he predicted that the spread of education, and the political empowerment of working people, would change this situation:

The relation of masters and work-people will be gradually superseded by partnership … perhaps finally in all, association of labourers among themselves. (The Principles of Political Economy, 1848)

Why do you think Mill’s vision of a post-capitalist economy of worker-owned cooperatives has not yet occurred?

6.10 Principals and agents: Interactions under incomplete contracts

In the relationship between Maria and her employer, Maria’s work effort matters to both parties but is not covered by the employment contract. This leads to the existence of employment rents. If they had been able to write a complete contract, the situation would have been quite different. The employer could have offered her an enforceable contract specifying both the wage and the exact level of effort she should provide, and if these terms were acceptable to her, she would have agreed and worked as required. To maximize his profit he would have chosen a contract that was only just acceptable, so she would not have earned any rents.

This example is not unusual. In practice, all employment relationships are governed by incomplete contracts. Employment contracts often do not even bother to mention that the worker should work hard and well. And there are many other ways in which we interact without a complete contract:

• People and banks lend money in return for a promise to repay the full amount plus the stipulated interest. But this may be unenforceable if the borrower is unable to repay.
• Owners of firms would like managers to maximize the value of the owners’ assets, but managers have their own objectives (first class air travel, lavish offices) and managerial contracts often fall short of an enforceable requirement to maximize the owners’ wealth.
• The contracts signed by tenants renting apartments may include clauses requiring that they maintain the value of the property. But aside from gross neglect, the liability for not maintaining the property is unenforceable.
• Insurance contracts require (but typically cannot enforce) that the people who purchase insurance should behave prudently and try not to take risks.
• Families devote a sizeable fraction of their budgets to purchasing educational and health services, the quality of which is rarely specified in a contract (and would be unenforceable if it were).
• Parents care for their children with the hope, but no contractual assurance, that their children will reciprocate when the parents are old and unable to work.

For these and a great many other exchanges, it appears that Emile Durkheim (1858–1917), the founder of modern sociology, was right when he observed that ‘not everything in the contract is contractual.’ As above, there is usually something that matters to at least one of the parties that cannot be written down in an enforceable contract.

Why are contracts incomplete?

Thinking about some examples of economic interactions, we can see that there are several reasons for the absence of a complete contract:

• Information is not verifiable: For a contract to be enforceable, relevant information must be observable by both parties, but also verifiable by third parties such as courts of law. The court must be able to establish whether or not the requirements of the contract were met. Verifiable information is often unavailable: for example, it may be impossible to prove whether the poor condition of a rented apartment is due to normal wear and tear or the tenant’s negligence.
• Time and uncertainty: A contract is generally executed over a period of time, for example specifying that Party A does X now and Party B does Y later. But what B should do later may depend on things that are unknown when the contract is written. People are unlikely to be able to anticipate every possible thing that might happen in future—and trying to do so would probably not be cost-effective.
• Measurement: Many services and goods are inherently difficult to measure or describe precisely enough to be written into a contract. How would the restaurant owner measure how pleasantly his waiters interact with customers?
• Absence of a judiciary: For some transactions there are no judicial institutions (courts or other relevant third parties) capable of enforcing contracts. Many international transactions are of this type.
• Preferences: Even where the nature of the goods or services to be exchanged would permit a more complete contract, a less complete contract might be preferred. Intrusive surveillance of workers by employers may backfire if the employer’s distrust angers the workers, leading to less satisfactory work performance. You do not necessarily want to know the exact quality of a concert before you buy the ticket—discovering it may be part of the experience.

Principal–agent models

Many contractual relationships can be modelled in the same way, as a game between two players, whom we call the principal and the agent, who face a conflict of interest. These are known as principal–agent problems. In the case of Maria and her employer, the employer is the principal. He would like to offer Maria, the agent, an employment contract, and she wants the job, but the amount of effort she will provide cannot be specified in the contract because it is not verifiable. This is a problem because there is a conflict of interest: he would prefer her to work hard, whereas Maria prefers an easy life.

Our model of Maria’s employment is an example of a general class of principal–agent models, in which an action taken by the agent is ‘hidden’ from the principal, or ‘unobservable’.

• The agent can take some action (such as working hard),
• the principal benefits from this action,
• but taking the action is something the agent would not choose to do, perhaps because it is costly or unpleasant (this is the conflict of interest),
• and because information about the action is either not available to the principal or is not verifiable,
• there is no way that the principal can use an enforceable contract to guarantee that the action is performed.

In short: a hidden action problem occurs when there is a conflict of interest between the principal and the agent over some action that may be taken by the agent, and this action cannot be subjected to a complete contract. In these problems, information about the action is either asymmetric (the agent knows what action is taken, but the principal doesn’t) or unverifiable (it cannot be used by a court to enforce a contract).

The table in Figure 6.8 identifies the principals and agents in the examples from this section.

Figure 6.8 Hidden action problems.

Information is verifiable if it can be used in court to enforce a contract. Non-verifiable information, such as hearsay, cannot be used to enforce contracts.

Information that is known by one party but not another is asymmetric.

We study the banker-borrower principal–agent model in Unit 10. In Unit 12 we will introduce the second main class of principal–agent models, in which it is not the agent’s action that cannot be contracted (hidden action) but rather something about the agent herself that is unknown to the principal (hidden attribute).

For each of the following examples, explain who is the principal, who is the agent, and what aspects of their interaction are of interest to each and are not covered by a complete contract.

1. A company hires a security guard to protect its premises at night.
2. A charity wants to commission research to find out as much as possible about a new virus.

6.11 Conclusion

The products of people’s labour may be transferred to others in markets, or within firms through employment contracts. To understand the role of the firm, we view it not only as an actor, but also a stage on which three sets of actors (owners, managers, and employees) interact. Principal–agent models help us understand how firms work by identifying the consequences of the conflicts of interest between the actors, when these cannot be resolved by complete contracts.

Employment contracts are incomplete: they can cover hours and some working conditions, but not the effort provided by the employee, which is not verifiable. So employers set wages that are higher than workers’ reservation wages. Workers receive an employment rent, which motivates them to work hard and deters them from quitting. When all employers set wages in this way, there will be involuntary unemployment in the economy. Public policies such as the provision of unemployment benefits change workers’ reservation wages and best response curves, and so affect the wage-setting process.

Before you move on, review these definitions:

6.12 References

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