The expectation measure, labor contracts, and the incentive to work hard

Under American or Dutch law, employees who leave the firm earlier than expe cted do not have to compensate the employer fur lost profits in most cases. This conflicts with the general view in law and economics scholar-ship tha t the expectation measure is the superior remedy. We argue that the promisee (the employer) should not be awarded compensatio n for lost expected profits if the promisor (the employee) can vary his lev el of effort, which is a typical feature of labor contracts. The ex post ex pectation measure undermines the incentives to work hard (i.e., above the d efined minimum level) because the higher the employee's productivity, the h igher the expected lost profits for the employer in case of breach. Our conclusion holds even if the first employer earned rents, or if the emp loyee likes to work, or if courts undercompensate. The ex post expectation measure improves the employee's incentives only if markets seriously overre act to productivity signals. We also analyze the incentive properties of 3 alternative expectation measu res. The ex ante minimally expected profits measure does not change the inc entives to work hard, but if the expectation measure is defined in terms of potential (maximal) or optimal productivity, the incentive to work hard is seriously undermined. We also show that the ex post expectation measure ma y create unemployment in that it inefficiently deters employees from enteri ng into labor contracts. Contrary to the current view in law and economics scholarship we show that the expectation measure can be a barrier to efficient breaching. It destroy s the information necessary for efficient breach by undermining the employe es' incentives to signal on the market how productive they can be. As a con sequence, competing employers no longer receive the information they need t o make better proposals. (C) 2001 Elsevier Science Inc. All rights reserved . JEL classification: K31; J41; J63.