Implicit Contracts

Definition

Implicit contracts are unwritten, informal agreements that govern the relationship between employers and employees. They represent the unspoken expectations and obligations that are understood, but not explicitly stated, in the employment relationship.

5 Must Know Facts For Your Next Test

1. Implicit contracts help explain why wages may be 'sticky' and slow to adjust to changes in market conditions, as employers are reluctant to violate the unwritten agreements with their workers.
2. The existence of implicit contracts can contribute to labor market inefficiencies, as they may prevent the optimal allocation of workers across firms and industries.
3. Implicit contracts are often used to justify the payment of efficiency wages, where employers pay more than the market-clearing wage to improve worker productivity and loyalty.
4. The insider-outsider theory suggests that implicit contracts create a divide between current employees (insiders) and potential new hires (outsiders), leading to labor market segmentation.
5. Implicit contracts can be influenced by cultural norms, industry customs, and the history of the employment relationship between a firm and its workers.

Review Questions

• Explain how implicit contracts can lead to wage 'stickiness' and labor market inefficiencies.
  • Implicit contracts represent the unwritten, informal agreements between employers and employees that govern the employment relationship. These implicit contracts can lead to wage 'stickiness', where wages are slow to adjust to changes in market conditions, as employers are reluctant to violate the unwritten expectations of their workers. This can contribute to labor market inefficiencies, as the optimal allocation of workers across firms and industries may be prevented by the presence of these implicit agreements.
• Describe the relationship between implicit contracts and the efficiency wage theory.
  • The efficiency wage theory suggests that employers may pay workers more than the market-clearing wage in order to increase productivity, reduce turnover, and foster a sense of loyalty. Implicit contracts are closely tied to this theory, as the unwritten expectations and obligations between employers and employees can justify the payment of efficiency wages. Employers may use implicit contracts as a way to incentivize workers and create a sense of loyalty, which in turn can lead to higher productivity and reduced turnover.
• Analyze how the insider-outsider theory relates to the concept of implicit contracts.
  • The insider-outsider theory suggests that firms are more likely to retain and protect the jobs of current employees (insiders) rather than hire new workers (outsiders) due to the implicit contracts and investments made in the existing workforce. This theory highlights how implicit contracts can create a divide between current employees and potential new hires, leading to labor market segmentation. Employers may be more inclined to honor the unwritten agreements with their existing workers, even if it means forgoing the potential benefits of hiring new, potentially more qualified individuals from the outside.

Related terms

Psychological Contract: The unwritten set of expectations and beliefs that an employee has regarding the terms of the employment relationship with their employer.

Efficiency Wage Theory: The idea that employers may pay workers more than the market-clearing wage in order to increase productivity, reduce turnover, and foster a sense of loyalty.

Insider-Outsider Theory: The concept that firms are more likely to retain and protect the jobs of current employees (insiders) rather than hire new workers (outsiders) due to the implicit contracts and investments made in the existing workforce.