IMPLICIT CONTRACTS AND FIXED PRICE EQUILIBRIA structure is a factor to be reckoned with in labor supply decisions,5 but do not develop an operational definition of "fairness. 6 This is perhaps one reason why the relative wage argument did not gain ground in economics Students of human capital8 have provided another theory of layoffs, namely, that the accumulation of job-specific skills requires the sinking of certain expenses for hiring and training. This is an in- vestment the employer makes in anticipation that the worker will remain attached to his job, and one he amortizes over time by paying a wage rate lower than the trained employee's marginal contribution to the firm. If the firm should need to reduce employment in periods of slack demand, it will naturally choose to lay off first the least trained members of its labor force, those who represent the smallest undepreciated investment in training. This story is a satisfactory explanation of the incidence of layoffs g not of their existence; it tells us why layoffs fall on the least skilled workers but leaves open the question why they occur in the first place which is our concern here Furthermore the technical heterogeneity of labor that is crucial for this argument is itself an unnecessary complication in traditional macroeconomic models that are built on the simpler assumptions of homogeneous inputs and zero transaction The innovation in the early literature on implicit contracts Baily 1974; Gordon, 1974; Azariadis, 1975]was to view the employment relation not simply as a sequential spot exchange of labor services for money, but as a more complicated long-term attachment; labor ser- vices are traded for an insurance contract that protects workers from random, publicly observed fluctuations in their marginal revenue product. The idea, shown in Figure I, is that workers can purchase insurance only from their employers, not from third parties. Risk-averse workers deal with risk-neutral entrepreneurs whose firms consist of three departments: a production department that purchases labor services and credits each worker with his marginal See Akerlof (1980) for a recent attempt at a theory of wage rigidity based on 8. The standard refere e is Becker[ 1964]; our argument is due to Oi [1962]. odel of layoff incidence, see Azariadis [1976IMPLICIT CONTRACTS AND FIXED PRICE EQUILIBRIA 3 structure is a factor to be reckoned with in labor supply decisions,5 but do not develop an operational definition of "fairness."6 This is perhaps one reason why the relative wage argument did not gain ground in economics.7 Students of human capital8 have provided another theory of layoffs, namely, that the accumulation of job-specific skills requires the sinking of certain expenses for hiring and training. This is an in￾vestment the employer makes in anticipation that the worker will remain attached to his job, and one he amortizes over time by paying a wage rate lower than the trained employee's marginal contribution to the firm. If the firm should need to reduce employment in periods of slack demand, it will naturally choose to lay off first the least trained members of its labor force, those who represent the smallest undepreciated investment in training. This story is a satisfactory explanation of the incidence of layoffsg not of their existence; it tells us why layoffs fall on the least skilled workers but leaves open the question why they occur in the first place, which is our concern here. Furthermore, the technical heterogeneity of labor that is crucial for this argument is itself an unnecessary complication in traditional macroeconomic models that are built on the simpler assumptions of homogeneous inputs and zero transaction costs. The innovation in the early literature on implicit contracts [Baily, 1974; Gordon, 1974; Azariadis, 19751 was to view the employment relation not simply as a sequential spot exchange of labor services for money, but as a more complicated long-term attachment; labor ser￾vices are traded for an insurance contract that protects workers from random, publicly observed fluctuations in their marginal revenue product. The idea, shown in Figure I, is that workers can purchase insurance only from their employers, not from third parties. Risk-averse workers deal with risk-neutral entrepreneurs whose firms consist of three departments: a production department that purchases labor services and credits each worker with his marginal 5. This is apparent in Okun's posthumous book [1981], pp. 93-97. 6. Such a definition was later developed in welfare economics; see Varian [1974], Schmeidler and Yaari [1971]. 7. See Akerlof 119801 for a recent attempt at a theory of wage rigidity based on "norms." 8. The standard reference is Becker [1964]; our argument is due to Oi [1962]. 9. For a contractual model of layoff incidence, see Azariadis i19761