Fundamental Transformation and Contractual Reference Points in a Shapiro-Stiglitz World

Motivated by evidence of resilient labor markets, the purpose of this paper is to develop a rationale for smoothed disposable income in long-term employment relations. Through the lens of repeated moral hazard it provides a testable explanation for a cooperative lock-in of behavior and contributes to the twofold-role-of-wages literature with a third role: the role of aligning entitlement perceptions. Consistent with common characteristics of highly exposed sectors to the 2008-09 crisis, my model includes a critical threshold for product quality. Refining the discipline setting in Shapiro-Stiglitz's landmark model, it shows that incentive compatibility imposes Williamson’s fundamental transformation from ex-ante competitive setting to ex-post bilateral dependency, justifying to integrate the Hart-Moore (2008) model of contract-contents-as-reference-points: Quality consistent efficiency wages determine employees’ perceptions, equivalently constituting a contractual reference point. The third role of wages then predicts non-pecuniary shock absorption, correspondingly cushioning jobs and maintaining critical product quality. Following testable predictions derive from the sequential contract game: (1) Binding quality thresholds in production fundamentally transform competitive labor contracts into long-term employment relations and release reciprocal reference points as contract enforcement device, considerably protecting (i) employees’ remuneration from economic shocks and (ii) product quality from productivity shocks. (2) Corresponding labor market segments are characterized by sine-qua-non quality standards and fairly smoothed equilibrium unemployment (rates). Reputation denotes an important success factor, in turn imposing a severe negative impact on individual firms suffering from reputation loss, e.g. resulting from shading in response to CRP violation, with likely industry-wide spillovers. (3) Quality and incentive compliant shock adjustment of labor involves safeguarding of jobs with transmission channels at the intensive margin, eventually leading to labor market resilience (in terms of OECD (2012), where the model uses the two dimensions formalization with (absorbing) a) changes in total earnings and b) changes in the unemployment rate.