Fairness and Efficiency: The Rotten Firm Theorem

When contracting is not possible, a preference for fair exchange can generate efficient exchange, fully exhausting the potential gains from trade — or no exchange at all, leaving all gains from trade unexploited. A profit-maximizing firm offers a wage to a fair-minded worker, who then chooses how much effort to exert. The Rotten Firm theorem says: if the worker cares sufficiently about fairness and the firm employs the worker, the equilibrium transaction is Pareto efficient. However, even when gains from trade were possible, the firm may not to hire the worker because every “fair” transaction (acceptable to the worker) could be less profitable than the firm’s outside option. The theory explains a puzzle: why firms offer profit-sharing plans to non-management employees. JEL classification: D63, J33, J41, M52, D64