Labor Contracts and Risk Sharing

This paper analyzes the rationale and limits of using labor contracts as a risk-sharing mechanism by (1) discussing types of contracts and their characteristics; (2) deriving the optimal labor contract for risk-neutral firms and risk-averse workers; (3) contrasting the predictions of contract labor and spot labor markets; (4) discussing the limits of labor contracts as a mechanisms to allocate risks; (5) focusing on rural labor markets, where labor and land contracts provide substitutes and have implication in relation to risk allocation; (6) discussing government interventions; and (7) reviewing the empirical evidence with special emphasis on Mexico. Labor contracts remain a mechanism to allocate risks between employers and employees, and a contract equilibrium may dominate a spot labor market equilibrium. However, limits associated with costly enforcement of contracts and problems of adverse selection exist. The evidence suggests that firms offer contracts that provide insurance against both aggregate shocks and idiosyncratic productivity shocks.