Implicit contract theory

In economics, implicit contracts refer to voluntary and self-enforcing long term agreements made between two parties regarding the future exchange of goods or services. Implicit contracts theory was first developed to explain why there are quantity adjustments (layoffs) instead of price adjustments (falling wages) in the labor market during recessions.^[1]

The origins of implicit-contract theory lie in the belief that observed movements in wages and employment cannot be adequately explained by a competitive spot labour-market in which wages are always equal to the marginal product of labour and the labour market is always in equilibrium.^[2]

In the context of the labor market, an implicit contract is an employment agreement between an employer and an employee that specifies how much labor is supplied by the worker and how much wage is paid by the employer under different circumstances in the future. An implicit contract can be an explicitly written document or a tacit agreement (some people call the former an "explicit contract"). The contract is self-enforcing, meaning that neither of the two parties would be willing to breach the implicit contract in absence of any external enforcement since both parties would be worse off otherwise.

The interpersonal negotiation and agreement in implicit contracts contrasts with the impersonal and nonnegotiable decision making in a decentralized competitive markets. As Arthur Melvin Okun puts it: a contract market is like an "invisible handshake" rather than the invisible hand.^[3]