Profit-Sharing as the Optimal Wage Contract

This paper analyses the optimal wage contract when firms face demand uncertainty and workers care about employment stability. Workers choose the firm that offers the highest utility taking into account the future lay-off probabilities; firms choose the wage contract that maximises the residual share of the gains from production. For risk-neutral workers this occurs with any efficient wage contract so long as it matches the ex-ante outside option of the workers, i.e. all feasible efficient contracts are optimal. The feasibility is proved for the efficient profit-sharing case. For risk-averse workers with variable effort supply, profit-sharing contracts are further shown to provide effort incentives through both their efficiency wage and performance-related payout effects. The paper thus promotes profit-sharing contracts not only on the grounds of employment stability, but also on the basis of its efficiency and incentive effects. JEL Classification: J33, J23 ∗I am grateful to Sir James Mirrlees, Sir Partha Dasgupta, Hamish Low, Alan Manning and Bob Evans for their valuable comments. All errors are the author’s. Correspondence to: Kenjiro Hori, School of Economics, Mathematics and Statistics, Birkbeck College, Malet Street, London, WC1E 7HX, UK. e-mail: [email protected].