Efficiency wage and efficient redundancy pay

A dynamic version of Shapiro and Stiglitz's shirking model features a form of inefficiency which is not captured by the original static model. Since, incentive compatibility requires workers to enjoy state-independent rents, any offer by redundant workers to take a wage cut is not credible, as it is not ex post incentive compatible. This implies that, if films cannot commit on future filing ex ante, the number of redundancies is inefficiently high, as the externality, in the form of foregone rents, that firms impose on workers on severance cannot be traded. Redundancy payments make firms internalize the externality and fireless. Aggregate employment unambiguously increases and a Pareto improvement can be obtained provided all or part of the cost accrues to workers. (C) 2000 Elsevier Science B.V. All rights reserved. JEL classification: E24; J32; J41; J65.