Research Summary
Research Summary
The Role of Institutions in Overcoming Imperfect Monitoring in Relational Contracting (with Carmit Segal)
Description
In a world in which firms can be hit by transitory adverse shocks it may be too costly for any single worker to verify the true state of the world. In this case, it may not be possible for firms to lower wages in response to adverse shocks and still have the workers exert high levels of effort. Thus, they may need to adjust employment. Even though in equilibrium there is no untruthful claim of an adverse shock by the firm, punishment phases are still needed to sustain cooperation. The workers are faced with a collective action problem; monitoring effort is underprovided as each worker prone to free ride on other workers monitoring effort. If it were solved, efficiency of the entire interaction could be largely improved as full cooperation without punishment could be achieved on the equilibrium path. We suggest two solutions to this problem: a) Unions can serve as a coordination device to overcome the collective action problem. Interpreting the role of unions from this new perspective can help to shed light on a very puzzling empirical regularity: nominal wage cuts are almost never observed. But if they are observed, they occur almost always in unionized firms. b) Firms can take steps to lower individual workers' costs of observing the true state of the world. This could explain the endeavors of firms to improve the financial literacy of their staff.