Wage Contracts with Incomplete and Costly Information

Optimal wage indexation, as derived by Gray, was subject to criticism due to a lack of efficient use of information; failure to clear the market which resulted in non-optimal contracts; and the lack of an explicit use of welfare criteria. The purpose of this paper is to derive a wage contract scheme that is free from the above criticism, but is capable of preserving the insight of Cray's analysis. In so doing the analysis reveals the role of costs of information collection in a world characterized by incomplete information.The analysis focuses also on the interaction between wage indexation and costly information collection as alternative adjustment schemes.It is shown that the first depends only on relative variances, whereas the second also depends on aggregate volatility. The justification for labor contracts hinges on the cost of information collection and last minute wage negotiation.