Employment contracts as trade-offs

An employment contract is one of variable (usually indeterminate) length, able to be terminated by either party, where the employee agrees to accept direction of their labour during work hours and, in return:
• accepts no legal liability for following lawful directions;
• foregoes any claim on the residual income of the firm (including no liability to cover losses by the firm); and
• will be paid at least the agreed amount
on the understanding that the financial return to the employer from the labour provided at least covers the total cost of employing the employee.

In a small business, the employer can assess the value of an employee to the firm fairly directly. The larger and more complex the business is, the harder that is to do. A solution is to pay employees a “hostage premium”: more than they might otherwise earn, so they have more to lose and so are more likely to police their own productivity. Hence large businesses tend to pay better than small businesses. In the public sector, the premium is typically paid in security of tenure and generous retirement benefits to discourage misuse of government employees’ official discretions. (There are obvious productivity issues from that, of course.)

At the core of the employment contract is a right to control (pdf). If there is no right to control, the courts do not recognise it as an employment contract.

That employees are often under the control of people who are also employees raises principal-agent issues (famously in the matter of corporate governance but, even more so, in the public sector), but does not change the essence of the employment contract. Delegated control is still control.

Despite the right to control being at its core, and that it derives from common law master-servant notions (though the modern employment contract has far fewer implied items), the employment contract is profoundly different from slavery, serfdom, debt bondage or any other form of bondage because neither the employee’s person, nor their labour services, is alienated as property.

Similarly, it is profoundly different from coverture marriage because no part of the employee’s property is covered and the employee retains their full legal personality, able to sue for breach of contract and to terminate the contract at will. That an employee retains their legal personality, can sue for breach of contract and is able to terminate the contract at will, with nothing to "buy out", is a marker that nothing is permanently alienated.

Similarly, it is not a pactum subjectionis, such as in a Hobbesian surrender of sovereignty or the dhimma pact of permanent and pervasive subordination, because nothing is permanently alienated: neither as some sort of bondage, nor giving up of personal sovereignty. In particular, there is no obligation to provide payments or services without direct recompense (such as taxes or tithes) involved, unlike the Hobbesian sovereignty bargain and dhimma pacts. The acceptance of direction and provision of services under the employment contract is strictly for an agreed-payment basis and, again unlike such arrangements, one can sue for breach of contract.

The employment contract differs from a commercial contract in that:
• a contractor has legal liability for their actions; and
• a contractor accepts financial liability for their own efforts
because a commercial contractor is directed but not controlled. That is, they provide agreed, specified services; not a generalised promise of labour services-as-directed. “Other duties as directed”—a classic part of an employee duty statement—cannot be properly part of a commercial contract, because it would involve unclear and unbounded legal and financial liabilities.
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From this, we can see how much the denial of legal and financial liability in the employment contract is a necessary part of the acceptance of control: that is, of generalised, indefinite direction. It is not some alienation of the employee’s personhood, but a necessary trade-off for acceptance of the generalised, not-pre-specified direction that is the essence of control: trade-offs that arise precisely because the employment contract is a contract between free parties.

The state in particular needs the employment contract: it would obviously be unreasonable to make public sector workers financially liable for any budgetary shortfalls or to hold them legally liable for actions which flow from lawful direction. Conversely, it is disastrous if politicians become delegates of public sector workers, as can be seen from the travails of California, where that is very close to being the case.

Firms and trade-offs
Whether we accept the Coasian notion of a firm as being the range of “in-house” non-market transactions or the Barzellian notion of the firm extending as far as the equity-capital guarantee to cover any losses, an employee is part of the firm, an independent contractor is not. The transactions with the independent contractor are market transactions (so external to the firm) while those with an employee are internal to the firm.

Similarly, any shortfall between payment for the contracted service and cost to the contractor of providing it is the contractor’s liability (so external to the equity capital’s guarantee to cover losses). Any shortfall between the payment to the contractor and the financial benefit to the firm from the services provided is part of the equity capital guarantee, but that is true of any purchase. Including the purchase of the services of employees. What makes the latter internal to the firm is that the costs involved in the direct provision of their labour services are typically internalised by the firm, so that the issue of expenses in providing the labour services, beyond those involved in arranging their private affairs (going to work, providing childcare, etc.), does not arise for employees (and even those are sometimes taken over by the firm directly).

An independent contractor is typically responsible for the creation, maintenance and improvement in their own human capital—their skills and knowledge. The firm has no claim on their continuing services and so, beyond specific elements that might be involved in providing services for the firm, no incentive to invest in their human capital.

Firms do have continuing—though indeterminate in length—claims on the services of their employees. Therefore, they have incentives to invest in the human capital of their employees, ameliorated by the fact that employees can still terminate the employment contract and use those skills elsewhere. This leads to various arrangements—such as benefits for longevity of service, partial employee-payment and partial firm-subsidy of skills acquisition, preference for short courses, and so on—to maximise the chance that investment in the human capital of employees will earn a return to the firm.

It is legally possible for people to form firms where the managers are the delegates of the workers. That typically that only happens in partnerships—where the capital is embedded in the suppliers of labour. In other words, the capital is both inseparable and the decision-makers are risking their own capital (their reputation). There would be a significantly greater risk premium in providing capital to a firm where the capital was only hired and poor incentives when the decision-makers did not gain from increasing the capital value of the firm.

In other words, such “labour-cratic” firms would have the typical incentive problems of the public sector. Which is presumably why we do not see them. Instead, the application of capital to labour is handled by employment contracts or commercial contracts.

The characteristics of employment contracts make sense if one examines them. In particular, they make sense in terms of trade-offs between the contracting parties. (Hence the tendency within common law towards fewer implied elements.) Modern discomfort with the notion of one citizen having a right of control over another in a private arrangement—and that incumbent employees (and those dependant on their income) are a large segment of the electorate—has, conversely, encouraged burgeoning regulation of the employment contract: typically to reduce or restrict the right of control (such as over termination via “unfair dismissal” regulation). But, precisely because the employment contract is based on a series of trade-offs, such regulation can have unfortunate effects.

For example, the high minimum wages, and grave difficulties in sacking people, of French law do much to explain the social disasters of the banlieues, the French housing estates. The harder it is to sever an employment relationship, the riskier it becomes to begin it. The more productive someone has to be to make starting an employment relationship worthwhile, the less such relationships will be engaged in. Instead, people retreat to ways of reducing the risk: they insist on more certification; they use networks so people they know can, in effect, vouch for any new person; they minimise risks in communication by hiring people most like themselves, and so on. Consequently, if you are a young Muslim male from those French housing estates, your chances of getting a job are greatly reduced. Living lives of idle resentment, burning a few cars provides cathartic excitement.

In other words, if regulators change the trade-offs within employment contracts, various commercial responses to “re-balance” them will occur that may impose significant social costs—such as the reduction in employment opportunities for marginal workers that come from making employing people more expensive and riskier.

Adding to expense and increasing complexity “locks up” potential resources. This encourages movement to other ways of applying labour to capital in order to unlock those resources. Such as, for example, agency contracting.

This then feeds into wider trends. With rising household incomes—particularly with marriages where both partners work becoming more common—the particular trade-offs of employment contracts (with their implicit income guarantees) have become relatively less appealing compared to various forms of self-employment and commercial contracting (with their greater flexibility). Using regulation to make mutually beneficial trade-offs harder to achieve via employment contracts—due to increased expense and greater restrictions—clearly tends to further discourage the use of employment contracts.

Complexity games
Encouraging complexity in the structuring of employment has been a prime union tactic, because complexity in employment contracts provides more:
• “services” they can provide members in administering that complexity;
• deals they can to with employers to lessen the cost of said complexity; and
• “bits” of income they can trumpet having “won”.
Hence, there is clearly a tension between the interests of unions and the interests of providers of labour that does much to explain shrinking union coverage.

Alas, regulatory complexity has powerful friends beyond unions:
• employer associations like it, because it also allows them to provide “services” to their members managing the complexity—the simpler the regulatory structure, the less there is for employer associations to “do”;
• bureaucrats like it, because it provides them with careers and expertise in managing it; and
• politicians like it, because it provides various benefits they can trumpet to particular groups of constituents.
The only people who do not like the regulatory complexity is everyone else who is trying to get income from productively matching capital to labour. But they are consumers of public policy, not producers of it.

It would be useful if the elements of employment contracts were more explicitly delineated: perhaps through a requirement to state the “cash equivalent” of various benefits—the greater transparency would make what are currently implicit (even hidden) trade-offs more explicit, making it easier for participants to see what they are actually getting, and what it is actually costing.

It is important to distinguish between the effects of regulation on commerce—the ability to transact to mutual benefit—from its effects on business—assets used to derive income. If you are in the business of providing services to “manage” regulatory complexity—as both unions and employer associations typically are—then regulatory complexity increases your business and the value of your “assets”. The naïve notion that employer associations automatically have the same interests as their members is as silly as the naïve notion that unions automatically have the same interests as their members. (Or that the interests of unions and employer associations are automatically opposed.)

Similarly, plenty of businesses like regulations that reduce their competition. What private enterprise likes is not necessarily what encourages free enterprise. Or vice versa.

For such complexity is a barrier to commerce because it gets in the way of people transacting for mutual benefit. The people who are most hurt by that are not the people with the most assets—the most money, skills, property—but the people with the fewest assets because they are the people who barriers to transact cut out first.

For example, the people who suffer from “unfair dismissal” laws raising the risks of employing people are small businesses and marginal workers. But they are, of course, precisely the people that have the least entrée into the arenas where public policy is produced and implemented.

But because people (particularly journalists) generally do not understand these complexities, employer association officials can be particularly effective opponents of regulatory simplification. They, after all, speak for “business” and cannot possibly be in the same game as the unions. Even though, in fact, they typically are.

In Australia they even share career paths—angling to be Commissioners. They may be on opposite sides in the “game” yet they have a deep, shared interest in the “game” continuing. But it is that “game” which is the central problem.

A game that is irredeemably of the negative kind of regulation; that which gets in the way of people transacting for mutual benefit, rather than facilitating it.