Relational Contract, Limited Liability, and Employment Dynamics

This paper shows that, by adding a limited liability constraint to a standard relational contract model with imperfect public monitoring, one can obtain de…nitive empirical implications of optimal relational contracts that shed light on important features of employment relationship. First and foremost, the employment dynamics has an “up-or-out”property. An employee begins the employment relationship in a probation phase, and depending on the outputs, either he receives permanent employment or the relationship is terminated forever. Second, the employee’s compensation is deferred in the sense that his expected compensation increases over time even if his expected productivity remain constant. In particular, the bonus payment as a proportion of his total compensation increases with time. Moreover, the turnover rate goes to zero as the employment duration goes to in…nity but the turnover rates need not to be monotone. For some cases, the optimal relational contract displays features of tenure: there is a …xed time in which the employee will be terminated if no permanent employment is obtained prior to that. Finally, employment is path dependent. Earlier success is more important both in terms of increasing future expected compensation and in terms of reducing the probability of termination. JEL Classi…cations: C61, C73, J33, L24