Bonding Shirking and Adverse Selection

Abstract

The most serious theoretical difficulty regarding shirking-type efficiency wage models is that the introduction of the so-called bonding scheme eliminates involuntary unemployment. This paper develops a shirking-adverse selection model where the resulting key feature is that labor quality within an individual firm negatively depends on the average amount of bonds in the market. Under this situation, a larger bond required by an individual firm will lower the firm`s labor quality and will discourage it from bonding its employees to the limit. This adverse selection problem gives rise to the possibility that bonding cannot eventually eliminate involuntary unemployment. Moreover, a larger bond required by a firm also worsens the labor quality within all other firms (negative externalities). The presence of these negative externalities implies that the profit-maximizing size of bonds required by individual firms in the market may be too large from the viewpoint of social welfare. This opens a possible role for bonding legislation to achieve an equilibrium Pareto superior to the competitive equilibrium.