Firm-Specific Human Capital And Wage Contract: A Framework Of Incomplete Contract

In today's world, many countries are seeking to develop the industries that are more dependent on technology and skills, in which the application of knowledge and skills determines the productivity, performance and competitiveness. The importance of comparative advantage based on cheap labor or raw materials has declined relative to a particular resource based on value-added competitive advantage. This competitive advantage in part (usually a large extent) depends on the education level and skill level of employees. Since human capital or skills is the most important factor of production, then how to implement effective incentive for employees' human capital development naturally becomes an important issue to be resolved within the relevant institutional arrangements. If the firm is regarded as institutional arrangements reached between the two sides of employment, then an important content of the arrangements is the output or income distribution between the two sides of employment, which is the wage decision from the perspective of employees. Therefore, the remuneration payment system, which improves employees' current and future skills level, plays an importance role in the enterprise.From the domestic reality, China is in the process of industrialization, and the demand for high-skill or high-quality labor has increased.In recent years, the shortage of skilled workers without an effective solution is a vivid example.In addition, China is deepening economic system reform, and implementing the employment system reform in which the labor contract system to full employment as the center. The enterprise lack of internal systems, not yet mature. Meanwhile, under the condition of excess labor supply, this reform also led to some bias, which is the enterprise has the tendency of making the labor contract short-term by its dominant position. On the one hand, the employment institutional arrangements will certainly have impact on employees'investment and training conditions, and the effects of long-term and short-term employment system are not the same; on the other hand, the remuneration institutional arrangements will also have impact on employees'investment and training conditions. Furthermore, pay system and employment system are not two completely independent systems.Even to say, there is what kind of employment system, there is what kind of the appropriate pay system. Therefore, in this generally short-term labor contract that is generally short-term employment system environment, to study the salary payment system that improves the skill levels of employees has a profound revelation for the Chinese enterprises'wage system and employment system reform during the transition period.Based on the above realistic background, this paper chooses enterprise's wage system and specific human capital investment as the main objects of study, and focuses on the impact of wage contract arrangements on specific human capital investment, in order to explore the wage system that is conducive to the formation of employee's specific skills.Neo-classical human capital theory on the analysis of firm-specific human capital investment no doubt has made important contributions on our understanding of wages and skills development. But in some ways, this analysis has some limitations. The analysis implicitly assumes that information is complete, and at the beginning of the match, the employment contract clearly defines the wage before and after training and investment level. In addition, the contract is enforceable (in the event of a dispute between the firm and employees, the information contained in the contract can be confirmed by the court). Therefore it can be drawn that in equilibrium, the ratio of the two sides sharing the investment cost and revenue should be equal. Because of its complete contract assumption, on the analysis of wage contract, neo-classical human capital theory ignores the negotiation difficulties caused by the opportunism of both sides and does not consider the possibility of cheating and hold-up problems. The hold-up behavior of its consideration exists only in the case of unilateral investment (the non-investment side acquires a share of quasi-rent brought by specific investment by resignation or dismissal), and can be solved by both parties sharing the costs and benefits of investment to maintain long-term employment relationship. However, it is clear that the complete contract assumption is unrealistic. The firm-specific human capital investment and skills would present such severe problems of measurement, verification, and evaluation, and often can not specified in the contract, also can not easily be observed by a third party (the court), so resulting in hold-up problem of incomplete contract.The core of principal-agent theory is to design an effective mechanism to encourage agents "speak the truth" and "not lazy". Because this mechanism covers the rights and obligations of the parties under a variety of contingent states, it is a complete contract that does not need renegotiation, so the theory has been called "complete contract theory." In the principal-agent framework (or complete contract framework), the studies on wage contract enrich and deepen people's understanding of the complexity and diversity of the arrangements for the wage system, and provide a more convincing explanation on the application conditions, incentive effects and limitations of various wage forms. However, these studies mainly focus on how to motivate employees to work hard, and do not address the problem of firm-specific human capital, so can not answer the issue of wage contract set raised by the hold-up risk, which is caused by firm-specific human capital.Hold-up problem is the central topic of incomplete contract theory, which was first raised in the product contract, and drew a classical proposition "if the contract is incomplete, specific investment of the transaction parties will lead to hold-up behavior, which leads to inefficient specific investment". This proposition has triggered a series of studies on how to minimize the efficiency losses of an incomplete contract. Although in the framework of incomplete contract, on the protection of specific investment in product contract, academic researches have made considerable achievements, the employment contract within the firm is different from the product contract with the unique nature, and there is little specialized research on the hold-up problem in the employment contract and the related wage system in the framework of incomplete contract. Even a small amount of studies addressed the hold-up problem in employment contract and the related wage contract, but these studies have certain problems and limitations. This also shows from one side that the issues need further study.Drawing on the existing academic literature, this paper analyzes the wage contract's set and the protection for firm-specific human capital investment in the framework of incomplete contract. This is a progress relative to the studies of wage system in the framework of complete contract. In a sense, the analysis of incomplete contracts also uses neo-classical cost-benefit analysis. However, it introduces a more practical factor-"the incompleteness", with particular emphasis on the limitations of short-term arrangements in spontaneous spot market. In this sense, we can also say that the new analysis is an improvement of the neo-classical model.Compared with the existing relevant literature, the main contribution of this paper is in the following aspects:(1) In the environment of incomplete contract, this paper re-analyzes the hold-up problem by introducing the investment cost related bargaining mode into investment game, combining the factors that affect the bargaining power in traditional model and the behavioral factor of agents'equity preference, and regarding the investment cost as a source of bargaining power. This is a development of existing framework of incomplete contract theory. Existing analyses of hold-up problem with incomplete contract often simply assume that the outcome of negotiations on cooperation surplus usually has nothing to do with the parties' investment level in advance, which neglect the economic implications of sunk costs relevance caused by the equity preference. And this is not real. Even some analyses introduce investment cost relevance in the hold-up problems, but negate the original factors of bargaining power, the outcome of negotiations simply determined by the principle of equity. Through the introduction of the parties'equity preference in flexible wage contract, this paper proves that compared with investment cost irrelevant with the outcome of negotiations, in the circumstance that investment cost relevant with the firm's (employee's) bargaining power, the two sides have more incentives for specific human capital investment. The hold-up risk faced by employer and employee depends on the parties' initial bargaining power:the party with relatively weak initial bargaining power will face hold-up risk, leading to his under-investment; the party with relatively strong initial bargaining power will not face hold-up risk, leading to his over-investment; the parties with equal initial bargaining power, both parties will not face hold-up risk, their investment levels are socially optimal levels. This conclusion provides an important economic implication for giving to the both sides of employment equal status.(2) This paper introduces relational contract based on reputation in the environment of incomplete contract, and models the relationship between the dual promotion levels within the firm and firm-specific human capital investment, which provides a new perspective for understanding the relationship between specific human capital investment and reputation. Relational contract theory and incomplete contract theory are two types literature of analyzing the parties'game behavior under symmetric information environment. The relational contract literature usually analyzes the parties'incentive problems under infinitely repeated games in a dynamic environment. However, incomplete contract literature usually analyzes the parties'incentive problems brought by hold-up in the context of a one-time game. This paper combines the two theories to analyze the firm's internal promotion system, which is an improvement to the existing theoretical framework. By analyzing this paper proves that, for the firm with high reputation, dual promotion ranks can achieve the incentive for skill acquisition and the efficient allocation of work simultaneously. With the improvement of reputation, the firm will induce skill acquisition relying on more horizontal promotion ranks, less vertical promotion ranks, and total surplus increase, corporate profits increase. This conclusion provides the economic implications for the wage compression of different work in the firm.(3) This paper introcuces the impact of union on promotion rules in the environment of incomplete contract, and analyzes employee's job-change, tenure and wage growth in the enterprise under the promotion rules that employee's promotion is codetermined by employee's human capital characteristcs and seniority. Further, this paper provides a comparative static analysis for the impact of the changes in external labor market conditions and hierarchical structure in the enterprise on employee's quitting decision and tenure. By analyzing this paper proves that:1) if wage increases with the work ladder, the high capacity employees in the enterprise will have relative long tenure, low turnover rate; 2) the external labor market conditions can affect the employee's tenure and the separation function of promotion system:when the labor market is tight, the lower mobility cost makes the employees with high enough ability stay in the enterprise eventually, with longer tenure; when the labor market is loose, the higher mobility cost makes a part of employees with relatively low ability also eventually stay in the enterprise; 3) the change of hierarchical structure in the enterprise will affect the possibility of the employees's stay in the current enterprise:if the type of work (or hierarchical level) fractionizes, i.e., lowers the ability level that is needed for employees to be promoted to the next level, with wage's corresponding changes through the job evaluation system, employees will be more likely to remain in the current enterprise; and vice versa; 4) if reducing the probability of terminating employment in the enterprise, employees will be more likely to remain in the current enterprise, which further strengthens the union's role in the formation of long-term stability employment relationship.