INVOLUNTARY LAYOFFS IN A MODEL WITH ASYMMETRIC INFORMATION CONCERNINGWORKER ABILITY

This paper examines the contract between a risk-neutral firm and its r isk-averse employees, assuming that worker ability is privately learne d by the firm after a period of employment. Employers in an external s pot labour market attempt to infer worker quality from the observable actions taken by the firm (such as the number of workers it lays off). The threat of spot market raids distorts the optimal contract. Layoff s may be involuntary and can exceed efficient levels. A seniority layo ff rule may be included in the contract to avoid the adverse selection problems that arise if layoffs are conducted on the basis of ability.