Dismissals and Match-Specific Rents

Labor contracts that result in dismissals are quite common in the real world. The question that arises is why employers do not just offer reduced wages instead of asking workers with low realized productivity to leave. This paper argues that such behavior can be explained by workers' understandable unwillingness to agree to contracts that an employer will not have an incentive to honor in the future. Specifically, we construct a matching model in which the employer and the worker are both uncertain about the value the other places on the match. Because the worker's match-specific productivity is the employer's private information, a commitment to pay a wage equal to the worker's value of marginal product is not enforceable. In the absence of a wage guarantee, the employer will offer retained workers wages below their value of marginal product, which causes quits to be inefficiently high. The employer can reduce quits by contractually promising a guaranteed wage to retained workers. Although this will lead to some involuntary dismissals, the loss from dismissals will be less than the gain from lower quits if the wage guarantee is not too high.