CONTRACTING AND INSIDER-OUTSIDER MODELS OF UNEMPLOYMENT 

From  the  Walrasian  assumption  of  a market-clearing wage  on  efficiency considerations  -  it was  postulated  that  a higher  than market-clearing wage  leads to  increased efficiency of workers for one reason or another. In this section we consider briefly  some models wherein the  wage  differs  from the  Walrasian  wage because  of  long-term  relations between workers and firms. We consider  here, very briefly, two kinds of models -  contracting models and insider-outsider models. 

The  rationale  underlying the contracting .models  is  that  firms do  not  hire workers  afresh  each period. Workers continue  to work  for a firm  for  a large number  of  years because many  jobs  involve firm-specific  skills  that  are  not valued as much outside the firm and also because firms would find  it costly to trbin new workers in these skills afresh each period. Workers are content to stay in  their current  jobs  so  long  as their expected earnings over a much  longer period than just,  say, the current year are more than the opportunities that  the workers would have outside the firm, even if  in the current year  their earnings are  low. A  worker  in  the United  States,  for  example, lasts  in  a  job, on  an average,  for ten  years.  In  such a situation wages do not  have  to adjust every period  to clear the  labour market  and  the  labour market clearly becomes non- Walrasian. 

The relationships between workers and  firms are determined in  such cases by long-term  contracts, arrived at through collective bargaining between worker unions  and  firms. We  can consider two kinds of contracts. The first kind  is a fixed-wage contract under which the wage is pre-determined and the film is free to choose the level of employment that it provides depending on the itate of the economy  that  emerges in each period. Workers agree to supply all  the  labour demanded by  the  firm. Wage  rigidity and  unemployment emerge  immediately in such a model. A fall in labour demand does not affect the real wage because of  the  contract.  The  labour supply  too cannot fall. The  only  thing that  can happen when  labour demand falls is that firms reduce employment at the fixed real wage. 

The  problem with  this  type  of  fixed-wage, variable  employment  contract  is, however,  that  it  is  not  an efficient  contract because, under it,  the marginal product of labour is generally not equal to the marginal disutility of work, and so  it  is possible to make  both  parties  to  the contract better OK You  should recollect from your microeconomics units that contracts are said to be efficient if it is  not  possible  to make  one of  the  parties better off without making  the other one worse off  (pare to efficiency). This takes us to the  idea of  implicit contracts, which are efficient contracts unlike the simple fixed-wage contracts. 

Implicit contracts are contracts between the firm and workers wherein the firm specifies  the real wage and the employment that it will provide for each possible state of the economy. The contracts are so called because actual contracts in the real world do not  explicitly specify employment and wage as a hction of the state of the economy. Not only are these contracts efficient, but also imply real wage rigidity and the consequences of real wage rigidity that we have examined in other contexts. The  insider-outsider models are  a development  on the  contracting models, wherein  three categories of  agents are recognised, viz., the firms,  the workers that are employed (insiders),  and  the unemployed workers (outsiders). It is  in the  interest of  the unemployed workers that the  firms and  the insider workers sign contracts providing for lower real wages and higher employment. But  the unemployed, being  outsiders, are  not  on  the  bargaining table. The  real  wage rigidity,  that  is  implied, provides a non-Walrasian characteristic to  the  labour market  and  explains the existence of unemployment. Rich models have been built up in the literature analysing the  interactions between the three categories of  agents to explain  some  of  the empirically observed characteristics of  the labnur market. New Keynesian Theories of Unemployment