Employment Uncertainty and Wage Contracts in Frictional Labor Markets ∗

Two essential aspects of many employment relationships are, (1) that they are meant to last a long time, and (2) that the participation of the worker and the firm in the match cannot be enforced during the relationship. I construct a model which takes the bilateral uncertainty of participation seriously, and characterize the optimal contract. In a frictional labor market, risk-neutral workers randomly receive opportunities to leave the firm. At the same time they are uncertain about their productivity in the match, and therefore about the (future) participation of the firm. Thus, in equilibrium, each party’s participation decision depends on the expected participation decisions on the other side. In the model, firms post wage-tenure contracts, trad-ing off instantaneous profit with the need to retain its workers, especially the workers in high-productivity matches. In the resulting wage-tenure schedule, wages can exhibit gradual growth over the course of the employment relationship, driven by (and responsive to) precisely the bilateral nature of uncertainty. I then solve for the equilibrium in the labor market. Uncer-tainty about the participation on both sides affects the extent of labor market competition, even though both parties are risk-neutral ∗Job Market Paper. The most up-to-date version of this paper can be downloaded from my webpage www.econ.upenn.edu/∼lpv/lpvpaper.pdf. For many discussions, and a lot of inspiration, I thank Ken Burdett