Labor Contracts with Voluntary Quits

Abstract

This paper considers characteristics of labor contracts between the risk-neutral firm and risk-averse workers who have heterogeneous outside opportunities (alternative wages). The alternative wage, not verifiable by the firm, becomes known to the worker after costly on the job search. The worker voluntarily quits if the outside wage is higher than the contract wage in the firm. If the alternative wage is deterministic, then self-selection among workers over a menu of contract wages would achieve the firstbest with efficient allocation of workers in different firms (industries), i.e., productive efficiency, and perfect risk-sharing. If the alternative wages are stochastic, the second-best contract would emerge on a tradeoff between productive efficiency and risk-sharing. Workers who are induced to search in the second-best contracts are fewer than in the first-best; and workers given search are less likely to quit than the first-best. The severance payment for a voluntary leaver serves only incomplete insurance because the exact outcome of search is not known to the firm; and unsuccessful search which force workers to stay is only partially compensated. If search effort is not monitored, even fewer workers conduct search. In sum, workers' stochastic alternative wages, which is a private information, yield a contract which induces workers to conduct less search and quits less often than the first-best.