No. 105: When should a firm employ its workers? A relational contracting approach

Abstract

A principal contracts with an agent to repeatedly perform a task. The principal can choose between two organizational forms: employment or self-employment of the agent. The key distinction between the organizational forms is that, under employment, the principal is allowed to stipulate how the agent performs the task, whereas this is legally forbidden under self-employment. Due to incomplete contracts, the labor relationship must be governed by relational agreements, which are affected by the allocation of decision rights inherent to each organizational form. We show that employment typically leads to an overprovision of the agent’s action, compared to an underprovision under self-employment, and that employment relationships tend to be (i) more rigid and (ii) better suited to favorable production environments, relative to self-employment. We then use our model to analyze the impact of taxation, minimum wages and formal performance pay on the outcome of relational contracting and the ensuing implications for the principal’s choice of organizational form.