MICRO/THEORY: Regulating Dynamic Contracts; Dr McClellan Andrew (University of Chicago Booth)

Abstract:

We study optimal regulation of dynamic contracts in a market in which firms and agents meet sequentially, and the firms, who have private information about the match productivity, can offer long-term contracts. Left unregulated, firms use contracts to inefficiently restrict agent movement, and extract all surplus from agents. The regulator can restrict the set of permitted contracts which firms can offer.

We derive an optimal regulatory policy in which all contracts take a simple structure, comprising a signing bonus, a flat wage, and a termination fee if the agent wants to leave the relationship. Regulation links the permitted termination fee to the wage, to incentivize firms to offer higher wages to agents with better match productivity, in exchange for more protection from poaching. Our results provide insights into the debate on the regulation of non-compete clauses in employment contracts.

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