Contract Enforcement, Fairness, and Involuntary Unemployment

We analyze the impact of contract enforcement problems on the emergence of (involuntary) unemployment. In an experimental labor market where the trading parties can form long-term relationships, we compare a work environment where contracts are implicit in the sense that effort is observable, but not verifiable to a situation where contracts are “complete” and effort is enforced exogenously. In both treatments, firms can employ no, one or two workers. Efficiency is maximized when all firms employ two workers and all employees provide full effort. Our findings are as follows: unemployment is much higher in the treatment without third-party contract enforcement. More importantly, unemployment in this treatment is involuntary, being caused by the firms’ employment and contracting policy. Firms pay high wages but offer fewer vacancies than possible and (technologically) efficient. This policy, however, succeeds in eliciting high efforts from the employed workers. When complete contracts can be written, wages are close to the market clearing level, firms do not ration jobs, and unemployment is mostly voluntary. Our findings lend support to theories of efficiency wages based on gift exchange as well as models of unemployment as a worker disciplining device.