Bankruptcy and Unemployment in Optimal Wage Employment Contracts

Optimal wage employment contracts under asymmetric information have shown that, if the firm is risk neutral and has the informational advantage over the risk averse workers, the second best contract prescribes underemployment if and only if the workers view leisure as an inferior good, and overemployment if and only if leisure is a normal good. In this paper it is shown that if leisure is a normal good and that if the firm wants to avoid bankruptcy, the optimal layoff contract, with optimal severance payment, may prescribe unemployment. A stronger unemployment result is obtained in the absence of severance pay. Finally, it is shown that, if the contracts specify both the working hours and the number of empolyed workers, the optimal contract may exhibit unemployment with respect to both the number of workers and the working hours, provided few technological preconditions are satisfied.