Externalities from Contract Length

Abstract

An increase in the length of a firm's labor contract contributes to rigidity in the aggregate price level. This increases the variance of aggregate demand but decreases the variance of other firms' real wages. Under certain conditions, the net effect is to increase the variance of other firms' employment. This negative externality implies that the equilibrium contract length in a decentralized economy is greater than the social optimum-in other words, wages are too rigid. Copyright 1987 by American Economic Association.