A general equilibrium model of' optimal employment contracts is developed where firms have better information abotu labor's marginal product than workers. It is optimal for the wage to be tied to the level of employment, to prevent the firm from Flsely stating that the marginal product is low and cutting the wage. It is shown that an observed aggregate shock that leads to an interindustrv shift in labor demand and that would have no effect on total eniplOVIllellt Ln(ler symmetric information

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... ds to a reduction in employment when firms and workers have asymmetric information. 1 See Barro (1 98 1) for a sLrvey of the literatUre on Unol)serve(l mllolleV suL)ply shocks, and Grossman and Weiss (1 982) for a model with Unobserved real p)roducliCil shocks. Ufournal of Political EconorNa, 1 983, x1l. 91, no. 61 (?) 1983 by Ihe LUiversity of Chicago. All rights reserved. 0()22-38(08/8i3/91 ()i-()()()8$(1.5)(1 907 908 JOURNAL OF POLITICAL ECONOMY affects the price level or aggregate unemployment) is observed by everyone. However, the shock increases workers' uncertainty about their marginal value products. We show that this increase in uncertainty causes employment to fall below the complete information level. Grossman and Hart (1981) and Azariadis (1983) analyzed the optimal labor contract between a firm and its workers in a partial equilibrium model where the firm has better information than workers about the real profitability of employment. If the firm is risk averse, optimal risk sharing implies that it should cut its real wage bill when it suffers from low profitability. When the firm's profitability, i, is unobservable to workers, however, the wage bill cannot depend directly on s. Instead, if the wage bill is to be reduced, the firm will have to reduce employment as "proof"' that labor's marginal product has fallen. In particular, the firm and workers will agree ex ante to a labor contract w(l; P) that ties the wage bill w to employment 1, and the realization of' a random variable P denoting public information. Suppose that when P = nj, workers have complete information about their marginal value product, while P = n2 denotes an aggregate shock that creates uncertainty about the marginal value product of labor. When P = nI, the optimal labor contract will involve productive efficiency (since there is complete information), and hence the marginal wage bill w1(l, nI) and labor's marginal disutility of effort, say R, will be equated. On the other hand, if n = n1, it can be shown that risk sharing dictates that w,(1, n2) exceed R. Hence there will be underemployment in low marginal product firms (but there will not be overemployment in high marginal product firms). This implies that total employment will be lower when P = n2 than if information were complete or labor were allocated through Walrasian spot markets. Consequently, shocks that move the economy from kiI to n2 but do not affect total employment with complete information or with labor allocation through spot markets lower total employment when there is asymmetric information. Section II reviews optimal asynmmetric information contracts for a single firm. Section III presents an introductory general equilibrium model in which an observed economy-wide shock affects the physical productivity of' labor. Workers know only the cross-sectional distribution of' productivities across firms that the shock induces. For example, workers may know that an oil price shock lowers labor productivity by 75 percent in half the firms and raises it by 75 percent in the other half. However, a given worker does not know which half' his firm is in. This captures the idea that workers know how the total demand for labor varies with the observed shock but not how their own firm's demand for labor is affected by the shock. We show that UNEMPLOYMENT 909