Organizational Design and Technology Choice with Nonbinding Contracts

Organizational Design and Technology Choice with Nonbinding Contracts

By Jeffrey Zwiebel, Lars Stole
1993Working Paper No. 1255

We present a new methodology for studying the general problem of labor contracting within a firm's boundaries where contracts provide only a minimal commitment to wages and employment. Given the peculiar contractual incompleteness of labor contracts, the resulting wages and profits under a large class of complete information bargaining games distort the technological and organizational decisions facing the owner of the firm's capital. We show that in such settings where firms consist of a nexus of nonbinding labor contracts, these decisions are distorted in an economically distinct way compared to the standard neoclassical firm. Among other things, we demonstrate that a firm with a nonbinding contractual basis will, relative to a neoclassical firm, (i) overemploy labor, (ii) underemploy capital, (iii) choose inefficient "frontload" technologies, (iv) de-emphasize scale and scope economies, and (v) inefficiently allocate labor across productive assets. We apply our analysis to product market competition, unionization, hierarchical management, and horizontal mergers.