The Upside of Implicit Downsizing Costs

Abstract: Downsizing can be associated with substantial implicit costs for a firm. In particular layoffs often seem to indicate “unfair” behavior towards employees who subsequently lose trust in the firm's promises. We show that these implicit downsizing or layoff costs can foster a firm's commitment in relational contracts formed with its employees. If a firm's optimal employment level is its private information, it might be tempted to wrongly claim that this level is low. This would decrease output, but also reduce payments that have to be paid to agents to reward them for their effort. To induce truth-telling, layoffs generally have to be accompanied by endogenous costs. These costs manifest in distortions that reduce output by more than what would be efficient. However, the distortions implied by downsizing are only temporary, hence the relational contract is not stationary: If the firm's prospects remain bad, output goes up again, and the distortions either completely disappear or at least are substantially reduced.