No. 105: When should a firm employ its workers? A relational contracting approach

Year: 2022
Type: Working Paper
Open Science:


A principal contracts with an agent to repeatedly perform a task. The principal can choose between two organizational forms, employment or solo self-employment of the agent. A key distinction between the organizational forms is that, under employment, the principal is allowed to stipulate how the agent performs the task, whereas this is legally forbidden under selfemployment. Moreover, under employment, the principal needs to guarantee a minimum wage. Under self-employment, only a non-negativity constraint on the agent’s payment applies. First, we solve a general model for the case of a non-verifiable task outcome. We show that, if the first-best is not attainable, employment leads to an overprovision of the agent’s action whereas self-employment leads to an underprovision relative to the first-best. If the discount factor takes intermediate values, the principal prefers employment when the agent is likely to have low costs and self-employment when the agent is likely to have high costs. Second, we consider the case of a verifiable task outcome under more specific model assumptions and focus on characterizing the range of discount factors for which the principal is able to induce the first-best under either organizational form. With a verifiable task outcome, enforceable and relational payments to the agent become imperfect substitutes. As a consequence, more attractive labor market prospects for the agent favor self-employment. In both contracting environments, increases in the minimum wage make employment less attractive to the principal.

Participating Institutions

TRR 266‘s main locations are Paderborn University (Coordinating University), HU Berlin, and University of Mannheim. All three locations have been centers for accounting and tax research for many years. They are joined by researchers from LMU Munich, Frankfurt School of Finance and Management, WHU – Otto Beisheim School of Management, ESMT Berlin and Goethe University Frankfurt who share the same research agenda.