Job Protection versus Contracts At‐Will: Trading‐Off Entrenchment and Shirking

• DOI: http://doi.org/10.1111/sjoe.12202
• Published date: 01 October 2017
• Date: 01 October 2017
• Author: Roman Inderst

©The editors of The Scandinavian Journal of Economics 2016.

Scand. J. of Economics 119(4), 939–961, 2017

DOI: 10.1111/sjoe.12202

Job Protection versus ContractsAt-Will:

Trading-Off Entrenchment and Shirking

Roman Inderst

Johann Wolfgang Goethe University, DE-60322 Frankfurt, Germany

inderst@finance.uni-frankfurt.de

Abstract

I compare two types of employment contracts: those offering job protection and at-will

contracts. Their respective performances reveal the following trade-off: at-will contracts

provide cheaper incentives for agents not to shirk, but they can induce the opportunistic

actions of agents to make themselves less dispensable (“entrenchment”). One implication

of the model is that more senior managers, such as chief executive officers, should

receive more protection, for example, through contracts that are explicitly not at-will

or contracts that specify a longer duration.

Keywords: At-will contracts; contract duration; employment agreements

JEL classification:D86

I. Introduction

In this paper, I solve the optimal employment contract for an agent

who must be remunerated for working hard and who must, at the same

time, be incentivized to take decisions in the firm’s, rather than only

his own, interest. The focus of the analysis is on an often overlooked

feature of employment agreements, for more senior employees including

chief executive officers (CEOs) in particular: contract provisions that offer

(more) employment protection, for instance through the explicit stipulation

of contract duration.

For the motivation, consider the empirical analysis of CEO employment

contracts in Schwab and Thomas (2006). They ask whether CEO contracts

are different from the standard “at-will” contracts used for lower-level

employees, and they find that CEOs are not generally “at-will employees”.

The agreements for CEOs offer far more protection, in particular through

contracts for a definite term of years (almost 87 percent of all cases)

and additional rights at termination. Schwab and Thomas (2006, p. 233)

conclude: “[t]his is quite different from the protections available to other

workers, who are generally at-will employees without contracts.” While

the last statement does not apply equally strongly outside the US, the

principles of my analysis should apply more generally.

940 Job protection versus contracts at-will

A key finding is that the optimal degree of such employment protection

must be chosen in light of the different tasks that an agent performs. In

terms of expected compensation costs alone, it is cheapest for the firm

not to offer any such protection, as this reduces the agent’s incentives to

work hard. However, in my model, this will negatively affect the efficiency

of decision-making. An at-will contract exerts additional discipline as it

allows the wage of a shirking employee to be renegotiates downwards.

However, the drawback of this is that the threat of such renegotiations

induces the agent to undertake actions that entrench his position in the

firm. Such incentives are absent when the agent is given (sufficient)

protection. In my model, shirking will relate to the absence of effort

to find a new strategy, while entrenchment will relate to the decision

to implement a new strategy too often, as this reduces firm profitability

under a new employee, thereby weakening the bargaining position of the

firm. A key implication that follows from this is that employees who have

more discretion, and whose (strategy) decisions have more impact on firm

profits, should be given (more) employment protection. In a similar vein,

this will also be the case when the scope for entrenchment is larger, as

the discretion that the employee can exert to shape the business makes

him less dispensable.

The theoretical analysis, based on a simple agency model of multi-

tasking, ties into a recent body of empirical literature that looks into the

details of employment agreements, in particular for CEOs. Importantly, for

such senior managers, legal provisions that protect workers’ rights, and also

agreements with trade unions, should be less important. At one extreme of

the spectrum of employment agreements that I consider is a contract “at

will”, for which I stipulate that, at any point in time, the firm can dismiss

the respective employee. This gives the firm a strong bargaining position in

possible renegotiations.1At the opposite extreme is a contract that offers

full employment protection, so that the respective employee can resist any

attempt to renegotiate his wage downwards under the threat of firing. I

also consider intermediate cases, where the degree of protection represents

a more gradual choice, as achieved, for instance, through contract duration

1“[E]mployers and employeescan avoid a possible charge of breach if they stick to the practice

of modifying terms only by mutual consent.…Mutual ag reement on modifications of terms

does not preclude wage changes—employees may agree to a wage cut if the alternative is

being laid off” (Malcomson, 1997, p. 1921). If the firm tries to renegotiate an employee’s

compensation downwards, and if the employeerejects the firm’s offer, the firm has two options.

It can either continue employment or fire the employee. If employment is continued, then

the existing wage contract remains in place: “refusal of an offer by either party followed by

continued employment leaves the contract unchanged” (Malcomson, 1997, p. 1933).

©The editors of The Scandinavian Journal of Economics 2016.