Optimal labor contracts with non-contractible human capital

The market for human capital is incomplete and therefore specific institutions must be designed to deal with this problem. An example of such an institution is lifetime employment (LTE), as observed in Japan. LTE coupled with an agreed-upon total wage bill will solve the moral hazard problem on the firm's side. On the worker's side, a tournament provides incentives for human capital investment. We show that the optimal contract will involve promotion of essentially all workers. Surprisingly, LTE can be more flexible than the policy of attaching wages to jobs that is often considered the "paradigm" American employment practice.