Labor and lemons: efficient norms in the internal labor market and the possible failures of individual contracting.

• Author: Kamiat, Walter
• Position: Symposium: Law, Economics, & Norms

Introduction

Edward Rock and Michael Wachter's article, The Enforceability of Norms and the Employment Relationship, contains two very different arguments. The first I find powerful; the second, unpersuasive.

The first, and far more general, argument focuses on the possible costs of rendering legally enforceable the informal norms adopted by parties in consensual economic relationships. The authors contend that the absence of an explicit contractual term rendering a norm legally enforceable may mean that the parties are following a strategy of exclusive reliance on self-enforcement, to their mutual benefit. They conclude that, even where the norms ordering a private relationship are themselves efficient--and even where such norms are unambiguously accepted by the parties as governing their relationship--it does not necessarily follow that the state should render those norms legally enforceable.

This conclusion seems to me to be clearly correct, as does their reasoning: (i) the legal enforcement of norms is likely to have transaction costs, including the costs of proving disputed facts to third parties, of defining the norms themselves to third parties, and of altering otherwise efficient behavior to account for the possibility of erroneous third party decisions; (ii) parties may be able to structure relationships involving mutually dependent investments in a way in which norms are effectively self-enforcing, protecting the parties against opportunistic behavior without needing legal enforcement; and (iii) if norms can be relied on to be "self-enforcing," rational parties may reject legal enforcement, relying instead on less costly self-enforcement schemes and sharing the savings.

In essence, arguing against any simplistic notion that it is cost-free to subject informal consensual relations to formal legal enforcement schemes, Rock and Wachter counsel: "If it isn't broken, don't fix it."

So far, so good.

But the issue in any given case is, obviously, whether the relationship at issue "is broken," that is, whether, in a particular context, self-enforcement is an effective alternative to third party judging. Where self-enforcement cannot effectively sanction opportunistic breaches of norms, state schemes of enforcement may well extend benefits that outweigh their costs. And, in a context where market failures render contracting costly or impossible, we should not expect to see norms embodied in formal contracts, even where state enforcement of the norms will be beneficial.

In Rock and Wachter's second argument, which constitutes the central thesis of their article, they tell a highly detailed story regarding the worker protective norms that govern internal labor markets in the private, non-union employment context. They conclude that their theoretical model validates the unreformed and controversial legal regime of employment-at-will, under which virtually all of the norms in question are legally unenforceable. But, in presenting their "if-it-isn't-broken-don't-fix-it" argument, the authors never seriously consider the possibility that the regime in question may indeed be "broken." That is, they never seriously consider the possibility that the worker protective norms at issue may not be effectively self-enforced and that the absence of formal agreements may reflect serious contracting problems, rather than a state of efficient contracting. While the factors they emphasize certainly play some role in explaining the virtual absence of individual just-cause contracts, so too may a variety of serious contracting problems--left unexamined by Rock and Wachter--that support far less optimistic interpretations of the employment relationship and that might well justify various kinds of state intervention.

1. Internal Labor Markets and Possible Employer Opportunism

   As the authors recognize, the regime at issue is one in which a host of employee protective norms (internal labor market norms) induce employees to make long-term investments in specific firms, thus tying the employees to those firms. In contrast to the near-uniform practice in unionized employment, these norms are virtually never embodied in express contracts.(1) Moreover, in contrast to the legal rules of virtually every other industrial democracy, these norms are deemed to be largely unenforceable by the legal system in the absence of express contracts (the employment-at-will rule).(2)

   In the internal labor market context, an unconstrained employer freedom to discharge would create a serious problem of employer opportunism, which would deter optimal investments in human capital.(3) An employee's firm-specific investments may, over the employee's work life, generate substantial value within the firm; but, those investments may also leave the employee less valuable over time with other firms, rendering the employee uniquely dependent on her current firm. The employee is further tied to the firm by accepting a promised schedule of career compensation that is backloaded (in part to enhance the power of the employer to police employee shirking). Among the results are: (i) the employee's promised compensation will, at some point, be significantly higher than she could obtain at a different firm, and (ii) her promised compensation, at the end of her career, may be higher than her marginal productivity within the firm.(4) All these factors may provide an employer with powerful incentives to breach the implied agreement late in the employee's career--for example, by unjustly discharging the employee (or by threatening to discharge in return for wage concessions)--since the norm against unjust discharge is legally unenforceable.(5)

   Although Rock and Wachter accept that investment in firm-specific human capital will be suboptimal to the extent that employees fear employer breaches of the relevant norms, they tell a complex story regarding how these norms might be self-enforcing and conclude that--despite the legal unenforceability of the norms--no legal reform is needed. Their story reduces, however, to an assertion that the near-uniform absence of non-union just-cause contracts demonstrates that employers are adequately constrained by the reputational costs of breaching the just-cause norm, leaving employees with no significant need (or desire) for the costly protection of legal enforceability.(6) They never earnestly consider that this pattern of noncontracting may reflect serious contracting problems in the non-union internal labor market, rather than efficient choices by the parties.

2. Labor Markets and "Lemons Problems"

   An analysis of why private employment contracting might not produce express terms embodying a just-cause termination standard might begin, as Rock and Wachter begin, with recognition that enforcing any such term would increase the costs to the employer of policing against employee shirking. Rock and Wachter conclude from this analysis that the parties' failure to adopt a just-cause provision reflects a judgment that employers are not likely to engage in opportunism to an extent that would justify these costs (divided between the parties). But this conclusion does not follow.

   A very different, but at least equally plausible, story focuses on how individual employment contracting over a just-cause term would present the parties with issues of unverifiable quality and asymmetric information regarding quality. The resulting contracting problems of signalling and adverse selection could lead to the breakdown of private individual contracting for the just-cause term. Under such circumstances, the failure of the nonunion labor market to produce just-cause terms through private contracting says little about how highly employees might value such terms or about the efficiency of such terms.(7)

   In essence, this story applies the "lemons problem" described in George Akerlof's The Market for "Lemons": Quality Uncertainty and the Market Mechanism(8) to the employment contracting context. Borrowing a phrase from the used car market, Akerlof's "lemons problem" is the inefficiency that characterizes a market in which buyers cannot easily verify the quality of goods offered by sellers, and sellers have superior (but hard to warrant) information regarding the quality of the goods they offer. In such a market, Akerlof shows, the ability of dishonest sellers to misrepresent the quality of the goods they offer (that is, to offer "lemons"), paired with the inability of buyers to distinguish between honest and dishonest sellers (that is, to determine which offers are "lemons"), will mean that prices will fall. As honest sellers disproportionately withdraw from a market that is undervaluing their offers (leaving a market with even more "lemons"), the price will fall further. In the end, a significant number of otherwise willing buyers and willing sellers will find it impossible to contract.(9)

   An employee and employer contracting for employment fits Akerlof's model: each possesses unique access to information--information regarding the quality of their offers--that the other party would find highly relevant, but which neither party can easily discover from the other. The employee, for example, has superior information regarding his likely work quality (including his skills and his propensity to shirk). The employer can only discover this information to a limited extent, and, fearing employee strategic behavior, the employer may have little reason to believe any representations of high work quality made by the employee. Similarly, an employer has superior information regarding the employer's likely conformity to worker protective norms, but the employee has little reason to believe representations of "trustworthiness" made by the employer.

   In this context, an employee who seeks an enforceable just-cause provision in the employment contract confronts a serious signalling problem regarding the quality of the employee's likely work. At least two kinds of...