In economics, implicit contracts refer to voluntary and self-enforcing long term agreements made between two parties regarding the future exchange of goods or services.
The interpersonal negotiation and agreement in implicit contracts contrasts with the impersonal and nonnegotiable decision making in a decentralized competitive markets.
In an effort to explain the layoff puzzle, models with implicit contracts were independently developed by Martin Baily, Donald Gordon, and Costas Azariadis in 1974 and 1975.
Under the implicit contract, a worker is able to reduce the fluctuation in their labor income and the employer is able to increase their average profit.
Hence naturally, economists tried to extend and apply the implicit contract theory to explain these phenomena in the capital market.
Some argue that the creditor-debtor long term relationship arises from the valuable "inside information" revealed via repeated bank-firm interactions.
[12] The relationship banking approach focuses on adverse selection as the main consequence of the information imperfection between lender and the borrower; however, there is also the problem of moral hazard.
Second, when a borrower, for example, a firm makes a bad decision that leads to its bankruptcy, it does not bear the full consequence of her mistake since part of the cost will be borne by the bank that helps finance the project.
Economists show that these problems could be solved by an implicit contract in which the borrower has to pay some costs when she defaults on the debt.
[15] However, since some of these costs will reduce the amount collectible to the lender in the bankruptcy, the expected rate of return is lower than if there were no moral hazard problems.
[18][19] Thus, despite its declining popularity among labor economists, implicit contract theory still plays an important role in understanding capital market imperfections.