Termination of Dynamic Contracts in an Equilibrium Labor Market Model
Forthcoming in Journal of Economic Theory (Originally published as WP #05024, July 2005 (Revised on July 1, 2008))
I construct an equilibrium model of the labor market where workers and firms enter into dyamic contracts that can potentially last forever, but are subject to optimal terminations. Upon a termination, the firm hires a new worker, and the worker who is terminated receives a termination compensation from the firm and is then free to go back to the labor market to seek new employment opportunities and enter into new dynamic contracts. The model permits only two types of equilibrium terminations that resemble, respectively, the two typical kinds of labor market separations observed in practice: involuntary layoffs and voluntary retirements. The model allows simultaneous determination of its equilibrium turnover, unemployment, and retirement, as well as the expected utility of the new labor market entrants.
JEL Classification: E20, J41, J63
Keywords: dynamic contract, termination, labor market equilibrium