Implicit contracts with effort incentives

The model combines the principal-agent approach with the analysis of labor contracts under demand uncertainty. Given the necessity to impose effort incentives the optimal contract is shown to maintain an efficient insurance with respect to the demand uncertainty and the employment risk. However, this efficient insurance may now yield either voluntary or involuntary layoff unemployment. Further, the optimal effort levels entail "underemployment" given a dominant strategy incentive mechanism as well as under a Nash-equilibrium mechanism. In contrast, the optimal employment levels fall short of achieving efficient production only in the latter case.