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CSEF - Center for Studies in Economics and Finance

Employment and wage insurance within firms: Worldwide evidence

17 June
by Andrew Ellul, Marco Pagano, and Fabiano Schivardi,

“The family business in Warroad, Minnesota, that didn’t lay off a single one of their four thousand employees during this recession, even when their competitors shut down dozens of plants, even when it meant the owners gave up some perks and pay … understood their biggest asset was the community and the workers who helped build that business…” (President Obama, 2012)

Labour income shocks are a major source of uncertainty for workers, who can be laid off or be subject to wage cuts when the firm they work for faces bad times. The possibility of losing the job weighs heavily on critical choices regarding workers’ careers, saving, home ownership and even raising a family. Differently from other types of risk, in fact, unemployment risk is hardly insurable through financial market arrangements, due to moral hazard – insured, a worker has no incentives to exert effort to keep her job or to look for another job if unemployed. As a consequence, most countries feature some form of government-provided unemployment insurance that pays benefits for some time after a worker becomes unemployed.

But there is an alternative provider of insurance for employees: the firm they work for. The idea that entrepreneurs insure workers against risk by giving them a stable income dates back at least to Knight (1921): “The system under which the confident and venturesome assume the risk and insure the doubtful and timid by guaranteeing to the latter a specified income in return for an assignment of the actual results ... is the enterprise and wage system of industry” (p. 269-70). This idea was formalised in the implicit contract model of Baily (1974) and Azariadis (1975), where risk-neutral entrepreneurs provide insurance to risk-averse workers by insulating their salaries and employment from adverse shocks to production, in exchange for a lower average salary.

The snag in a firm’s insurance provision to its employees is that, since the contract is implicit, the firm must be able to commit to honour its promises in the event of a bad shock. The firm’s ownership structure can play an important role in this respect. There is a good deal of anecdotal evidence that family firms have greater credibility as providers of insurance than non-family ones, as the epigraph above illustrates. Family firms are less likely to breach implicit contracts with their employees, because the reputation of the controlling family is at stake. Long-term ownership and control, possibly over generations, enable them to win the trust of their employees, giving them a strong incentive to keep their promises in order to retain it. Their credibility is also buttressed by their characteristic invulnerability to hostile takeovers, and hence to unforeseen changes in control, as argued by Shleifer and Summers (1988). In exchange for this security, they will be able to pay lower wages, effectively earning an ‘insurance premium’.

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