FINANCIAL DISTRESS AND UNDEREMPLOYMENT

A reasonable model of the labour market over the business cycle should predict, among other things, that (a) in very low states of product d emand there may be too little employment from an efficiency perspectiv e, but as the state improves employment will increase until ultimately it is efficiently deployed, and (b) in low states of demand, a worker 's welfare level will be ''low'' and as the state of the world improve s so will the worker's welfare, except, possibly, at high levels of de mand where the worker's utility may start to fan. Surprisingly, there does not exist a labour contract based model that is consistent with p redictions (a) and (b). In fact, the standard results in the literatur e are if leisure is a normal good then there will be too much employme nt in essentially all states of the world and the welfare of the worke r declines as the state of the world improves. In this paper a labour contracting model is constructed that is consistent with the above men tioned predictions. Two necessary ingredients in the model are the pos sibility of financial distress in low demand states and ''partial prov ability'' in contracting. Financial distress can be viewed as frustrat ing renegotiation and, thus, inefficient outcomes are possible in equi librium. Partial provability-the ability of an informed player to make verifiable claims or statements to an uninformed player-eliminates ce rtain kinds of inefficient outcomes. In particular, it eliminates the possibility that, in equilibrium, there is too much employment. This l ast result is interesting in itself because it is commonly believed th at normality of leisure necessarily implies that labour contracting mo dels will generate employment levels that are too high from an efficie ncy perspective.