LABOR CONTRACTS, PRODUCT MARKET OLIGOPOLY, AND INVOLUNTARY UNEMPLOYMENT

The simultaneous occurrence of (ex post) involuntary unemployment and underemployment is explained by strategic contracting of firms operati ng in oligopolistic product markets. Firms have an incentive to offer labour contracts in which wage payments (net of opportunity costs of l abour) exceed layoff payments. Such contracts increase marginal costs in bad states, thus relaxing price competition in the product market. In equilibrium this strategic incentive leads to inefficiently low exp ected employment, inefficiently high use of other inputs, and ineffici ent risk bearing by workers relative to the cost minimizing solution. When the product market becomes fragmented the distortions in the inpu t markets disappear.