Division of the Humanities and Social Sciences California Institute of Technology Pasadena, California 91125 Can Relational Contracts Survive Stochastic Interruptions?

This paper investigates the robustness of the “two-tiered labor market” experimental results of Brown, Falk and Fehr (2004) by subjecting relationships to stochastic interruptions. Using two different subject pools, we first replicate the basic pattern of high quality private contracting and low quality public contracting. We then study the impact of exogenous random ‘downturns’ in which firms cannot hire workers for three periods. Our hypothesis is that 1. job rents are lower in downturns 2. this will lower wages and effort, unless strong reconnection norms exist. We do find that job rents are lower, but surprisingly, the downturns do not harm aggregate market efficiency. Stochastic interruptions delay the formation of relationships, necessitating the use of public offers, which increases the competitiveness of the short term market. The high tier (private) markets responds by raising wages, thus increasing average worker surplus per trade. We also find evidence that 50-50 pre-downturn worker-firm surplus sharing predicts post-downturn reconnections. JEL classification numbers: D64, C90, L30