Market Competition and Informal Incentives

Abstract: We develop a model where firms compete on a product market and employ workers whose effort increases revenue, but where no formal contracts can be used to provide incentives for the workers. Firms and workers are matched on a labor market and wages are determined by a bargaining process. Both parties incur costs to find a new match, and these costs depend on competition in the labor market. In particular, more labor market competition (i.e., more available workers) reduces firms' replacement costs. We show that such a reduction decreases workers' wages, industry-wide production effciency, and consumer surplus. It also makes collusion between firms easier to sustain because the incentive to deviate from a collusive agreement is lower. By contrast, lowering workers' costs in the labor market increases workers' wages, production effciency, and consumer surplus - highlighting that there is a sharp asymmetry between reducing labor-market costs for firms and for workers. The mechansim we derive has interesting implications on a number of policy issues. For example, a higher minimum and a more stringent employment protection can increase effort and consequently production efficiency. Furthermore, more generous unemployment benefits have no adverse effects on a worker's effort.