Business 33032
Canice Prendergast
Managing the Workplace
Spring 2025
Topic 2
The Employment Relationship: Long Term Employment Relations
Note: at the end of this Topic, we will return to the following occupations:
Lawyers
Fruit pickers
Airline Pilot
Retail worker
Government Workers
Auto workers
Fast food worker
Manager in fast food restaurant
Sales force Workers
Chicago MBA students
We will address these issues in a number of steps:
1. Is the Spot Market Model a good representation of the real world?
2. If not, why not?
• Risk Sharing as one reason
3. The sensitivity of different jobs to economic conditions
4. Who should be laid off?
Is the Spot Market Model a good representation of the real world?
1. Average tenure with an employer (Tables 1 and 2).
Table 1
Observed Distribution of Job Tenure
Table 2
Distribution of Eventual Tenure
Category
Percent
Years
Percent
0-0.5
0.5-1.0
1-2
2-3
3-5
5-10
10-15
15-20
20-25
25-30
30-35
35+
19.0
9.2
11.7
7.7
12.5
16.7
8.7
5.0
3.7
2.8
1.7
1.3
0-0.5
0.5-1
1-2
2-3
3-5
5-10
10-15
15-20
20-25
25-30
30-35
35+
9.8
6.7
7.0
5.0
13.5
14.8
10.4
4.7
4.7
6.2
10.0
7.0
2. The elasticity of employment with respect to output
This is the percent change in employment divided by the percent change in product demand.
What does the Spot Market Model say that this should be?
Demand and employment
Underemployment
MRP < w
MRP > w
Overemployment
Employment
Output
Time
Employment over the business cycle.
Below we will consider how these curves vary for different jobs. These questions will address two
other issues:
The usual elasticity of employment is about 0.3.
1. What was it during the financial crisis of 2009? Larger or Smaller? Why?
2. Whose elasticities are larger: big firms or small firms? Why?
3. The volatility of wages and the returns to capital.
Remember that microeconomics says that all factors should be rewarded for their marginal
product or scarcity. Is this true?
Why not?
1. Legal Reasons or Hiring and Firing Costs (Topics 9 and 10)
2. Matching: (Topic 4)
3. Incentives: (Topics 4-7)
4. Human capital: (Topic 2)
5. Risk-Sharing - Worker’s need for income security
Risk Sharing and Employment
The key insight here is that workers who get laid off often face considerable risk in terms of
reemployment prospects and that firms can often profit from shielding workers from these risks.
Suppose that you employ a single worker in a firm. If times are "good", which occurs half the time,
she produces $100 worth of output. If times are "bad", which occurs the other half of the time,
then output is $45.
Let us say that the worker can take another job (say in the government) which offers a secure
income of $50.
If there was no risk of unemployment here, then the solution is simple:
(i) employ the worker in good times, and
(ii) lay off the worker in bad times (as $45 is less than $50).
However, let us extend this to consider a case where if the worker is laid off, she earns $30.
Two Scenarios
I: The worker is laid off in bad times.
Suppose the worker now knows that he loses his job when times are bad.
How much must she be paid to take the job?
What are expected profits?
II: Always employ the worker.
If this promise is credible, how much must the firm offer the worker?
What are profits?
How can the firm earn more money through violating the Spot Market model?
The reason is that the firm needs to consider the total surplus created by employment.
The rule that arises here is that if there are no bargaining problems in the employment
relationship, then all trades that increase total surplus should be implemented by the firm.
Note that this is not a moral argument; it is about profitable business practice.
Problem of Reputation
Some Evidence: The Returns to Hostile Takeovers
Academics have examined the value of hostile takeovers by considering what is known as
the excess return.
What was the excess return for hostile takeovers?
Does this mean that these takeovers were efficient?
An example: the airline industry.
More General Solution
How does the idea here relate to the Spot Market Model?
1. Firms employ fewer core employees than is needed in good times (marginal revenue
product > wage).
2. Firms employ more core employees than is needed in bad times (marginal revenue
product < wage).
DGood
DBad
w*
Nb*
What do firms do?
Ng*
Number of workers
DGood
DBad
w*
Nb*
Nb^
Ng^
Nb*
Number of workers
They adapt at both margins. At what cost?
DGood
Two costs.
DBad
MRP > wage
MRP < wage
w*
Nb*
Nb^
Ng^
Nb*
Number of workers
The Sensitivity of Employment to Economic Conditions
Lawyers
Fruit pickers
Airline Pilot
Retail worker
Government Workers
Auto workers
Fast food worker
Manager in fast food restaurant
Sales force Workers
Chicago MBA students (full time)
Relevant Factors in Adjusting Labor:
Specific skills
Wage adjustments when conditions change
Matching
Strategic use of deferred compensation
Substitution of capital for labor
Product market competition
One key issue this shows is its implications for the difference between the recruitment of new
talent versus the retention of existing talent.
We have said nothing about which workers should be let go.
The Spot Market Model is very clear here: see which workers bring in the least marginal
revenue product minus wages, and let those go. In reality, it is typically very different.
Often, it is done one of two ways – either through rules (last in, first out) that we return to in a
later topic. The second issue is voluntary layoffs.
Severance Payments – think of like a benefit decision (with selection problems)