User:Ling zhu md/Implicit Contracts

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In economics, Implicit Contracts refer to voluntary and self-enforcing long term agreements made between two parties regarding the future exchange of goods or services. The Implicit Contracts Theory was first developed to explain why we see quantity adjustments (

recessions.[1]

In the context of the

labor market, an implicit contract is an employment agreement between an employer and an employee that specifies how much labor is supplied by the worker and how much wage is paid by the employer under different circumstances in the future. An implicit contract can be an explicitly written document or a tacit agreement (some people call the former an "explicit contract"). The contract is self-enforcing, meaning that neither of the two parties would be willing to breach the implicit contract in absence of any external enforcement
, since both parties would be worse off otherwise.

The interpersonal negotiation and agreement in implicit contracts is in contrast to the impersonal and unilateral decision making in a

competitive market. As Arthur Melvin Okun puts it best: a contract market is like an "invisible handshake" rather than the invisible hand[2]


Implicit Contracts in Labor Market

Layoff Puzzle

In traditional economic theory, a worker takes his wage as given and decides how many hours he works. The firm also takes the wage as given and decides how much labor to buy. Then wage is determined in the market to ensure total labor supply equals to total labor demand. If workers supply more labor than firms demand, then the wage level should fall, so that workers will work fewer hours and firms would demand more labor. Hence, when firms reduce labor demand during a recession, we should expect to see a fall in wage as well. However, in reality, we see firms layoff redundant workers while keeping the wage unchanged for the rest of the workforce[3], and the wage compensation fluctuates considerably less than employment does in a typical business cycle[4]. Therefore, the law of supply and demand is insufficient to explain these phenomena we observe in reality.

Implicit Contract as Insurance

In an effort to explain the layoff puzzle, models with implicit contracts are independently developed by

insurance premium that workers pay for the stability in the insurance
schedule in the long run.

Decline of Implicit Contract Theory in Labor Economics

Despite its popularity in the 1980s, applications of the implicit contracts theory in labor economics has been in decline since 1990s. The theory has been replaced by search and matching theory to explain labor market imperfections.

Implicit Contracts in Capital Market

labor market discussed above: we often observe long term relationships between banks and borrowers just like the long term employment relationship between an employer and his workers. Like layoffs in the labor market, there is credit rationing
in the financial market. Also, a typical loan contract is just like an employment contract illustrated in the model above: the loan repayment is fixed in all states of nature as long as the borrower is solvent. Hence naturally, economists tried to extend and apply the implicit contract theory to explain these phenomena in the capital market.

The earliest studies to employ implicit contracts models in capital markets see the existence of credit rationing as part of an

default risk
in the capital markets. And implicit contracts have been playing an important role in explaining credit rationing under asymmetric information.

Implicit Contracts under Adverse Selection

Some argue that the creditor-debtor long term relationship arises from the valuable "inside information" revealed via repeated bank-firm interactions.

basis points lowering of loan spreads and that relationships are especially valuable when borrower transparency is low" by using data from US[10] However, using survey data from Japan, another recent study finds that the long term relationship between borrower and lender "in some cases increased cost, from stronger relationships for opaque borrowers and for borrowers who get funding from small banks. These latter findings suggest the possibility that relationship borrowers may suffer from capture effects". [11]

Implicit Contracts under Moral Hazard

The relationship banking approach focuses on adverse selection as the main consequence of the information imperfection between lender and the borrower; however, there is also the problem of moral hazard. In general there are two moral hazard problems related to the capital market. First, borrowers could lie about their financial situation and not repay their debts in full. If the lender could not check whether the borrower is lying, then there might not be any lending in the market at all, especially when the debt is unsecured. Second, when a borrower, for example, a firm makes a bad decision that leads to its bankruptcy, it does not bear the full consequence of her mistake since part of the cost will be born by the bank that helps finance the project. Therefore the firm is likely to make riskier decisions when the investment is financed by a bank than when the investment is financed out of the firm's own pocket. Economists show that these problems could be solved by an implicit contract in which the borrower has to pay some costs when she defaults on the debt. The borrower's cost of default can be the expense of hiring lawyers and accountants to persuade the lender of her financial distress[12], exclusion from capital market and future borrowing [13], or economic sanctions if the borrower is a country [14]. However, since some of these costs will reduce the amount collectible to the lender in the bankruptcy, the expected rate of return is lower than if there were no moral hazard problems. Therefore, the investment level would also be lower, causing credit rationing in the size of loans.


Implicit Contracts in Current Research

Credit rationing in the size of loans is also known as borrowing constraints. In recent years, many macroeconomists become interested in firm level data and firm behaviors. There is wide spread evidence supporting the conjecture that borrowing constraints may be important determinants of firm growth and survival.

asymmetric information between the borrower and lender.[17][18]
Thus, despite their declining popularity among labor economists, implicit contracts still play an important role in understanding capital market imperfections.

References

  1. ^ Azariadis, Costas., and Joseph Stiglitz., "Implicit Contracts and fixed Price Equilibria", The Quarterly Journal of Economics, Vol.XCVIII 1983 Supplement.
  2. ^ Okun, Arthur., "Prices and quantities", Wash., DC: The Brookings Institution, 1981.
  3. ^ Feldstein, Martin., "The Importance of Temporary Layoffs: An Empirical Analysis", Brookings Pap. Econ. Act., 1975, 3, pp725-44.http://www.jstor.org/stable/2534152
  4. ^ Hall, Robert., "Employment Fluctuations and Wage Rigidity",Brookings Pap. Econ. Act.,1980, 1, pp91-123.
  5. ^ Azariadis, Costas, "Implicit contracts and underemployment equilibria",Journal of Political Economy, 1975.
  6. ^ Baily, M., "Wages and employment under uncertain demand", Review of Economic Studies 41, 37-50, 1974.
  7. ^ Gordon, D.F., "A neoclassical theory of Keynesian unemployment", Economic Inquiry 12, 431-49, 1974.
  8. ^ Fried, Joel., and Peter Howitt., "Credit rationing and implicit contract theory", JMCB, 1980.http://ideas.repec.org/a/mcb/jmoncb/v12y1980i3p471-87.html
  9. ^ Sharpe, Steven A., "Asymmetric Information, Bank Lending, and Implicit Contracts: A Stylized Model of Customer Relationships", The Journal of Finance, September 1990.http://ideas.repec.org/a/bla/jfinan/v45y1990i4p1069-87.html
  10. ^ Bharath, Sreedhar T., Sandeep Dahiya, Anthony Saunders, and Anand Srinivasan., "Lending Relationships and Loan Contract Terms", Review of Financial Studies, first published online October 7, 2009.
  11. ^ Kanoa., Masaji, Hirofumi Uchidab., Gregory F. Udellc., and Wako Watanabed., "Information verifiability, bank organization, bank competition and bank–borrower relationships", Journal of Banking & Finance, Volume 35, Issue 4, April 2011, pp. 935-954.
  12. ^ Gale, Douglas., and Martin Hellwig., "Incentive-Compatible Debt Contracts: The One-Period Problem", The Review of Economic Studies, Vol.52. No. 4., 1985. pp.647-663.
  13. ^ Eaton, Johnathan., and Mark Gersovitz., "Debt with Potential Repudiation", Review of Economic Studies, April 1981, 48, pp.289-309.
  14. ^ Bulow, Jeremy., and Kenneth Rogoff., "A constant Recontracting Model of Sovereign Debt", The Journal of Political Economy, Vol. 97. No.1, 1989, pp.155-178.
  15. ^ Fazzari, Steven, Glenn Hubbard, and Bruce Petersen, “Financing Constraints and Corporate Investment,” Brooking Papers on Economic Activity, 1 (1988), 141–206.
  16. ^ Gilchrist, Simon, and Charles Himmelberg, “Evidence on the Role of Cash Flow for Investment,” Journal of Monetary Economics, XXXVI (1994), 541–572.
  17. ^ Clementi, Gian L., and Hugo A. Hopenhayn. 2006. “A Theory of Financing Constraints and Firm Dynamics.” Quarterly Journal of Economics, 121(1): 229–65.
  18. ^ Biais., Bruno., Thomas Mariotti., Jean-Charles Rochet., Stéphane Villeneuve., "Large risks, limited liability, and dynamic moral hazard", Econometrica, Volume 78, Issue 1, January 2010, pp. 73–118.



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