2010) "Relational Contracts, Limited Liability, and Employment Dynamics," Working Paper

This paper develops a tractable model of relational contract with imperfect public mon-itoring where the agent has limited liability. In the optimal relational contractort, both monetary reward for good performance and punishment for bad performance through ter-mination are used. Both are postponed as much as possible yet termination always occurs with positive probability. The optimal relational contract sheds light on a number of important patterns of employ-ment dynamics. First, employment relationship sometimes starts with a probation phase, after which the agent either receives permanent employment or is terminated. Second, the sensitivity of wages to performance increases with experience and wages are backloaded. Third, turnover rates can be inverse-U shaped with seniority. Fourth, earlier successes are more important for future wage growth. The tractability of the model also allows us to carry out several comparative statics that are typically di ¢ cult to obtain in discrete-time dynamic incentive models. Our technique of obtaining comparative statics uses properties of functional operators and may be of indepen-dent interest. Some of the comparative statics results shed new light on important policy issues. For example, minimum wage may harm workers who are already employed because they are more likely to be terminated