When should a firm employ its workers? A relational contracting approach
A principal contracts with an agent to repeatedly perform a task. The principal can choose between two organization forms, employment or solo self-employment of the agent. A key distinction between the organization forms is that, under employment, the principal is allowed to stipulate how the agent performs the task, whereas this is legally forbidden under self-employment. Moreover, under employment, the principal needs to guarantee a minimum wage. Under self-employment, only a non-negativity constraint on the agent's payment applies. We show that, with a non-verifiable task outcome, the principal prefers self-employment if the agent's costs may vary widely. With a verifiable task outcome, enforceable and relational payments to the agent become imperfect substitutes. As a consequence, the optimal organization form also depends on labor market characteristics. A high minimum wage as well as attractive labor market prospects for the agent favor self-employment.