We analyze the following questions associated with outsourcing and profit sharing under imperfect labour markets. How does strategic outsourcing influence wage formation, profit sharing and employee effort when firms commit to optimal profit sharing before wage formation or decide for profit sharing after wage formation. What is the relationship between outsourcing, profit sharing, and equilibrium unemployment depending on whether in other industries profit share is or is not a part of the compensation scheme. What is the optimal production mode in terms of strategic outsourcing. We find that if firms will decide on profit sharing before the wage formation, higher outsourcing decreases wage whereas profit sharing has an ambiguous effect. Under flexible profit sharing wage is higher if optimal profit share is small enough. For equilibrium unemployment, we find that if there is no profit sharing in other industries, outsourcing will decrease the unemployment rate. But if profit sharing is a part of the outside option, then this effect is ambiguous.
outsourcing profit sharing labour market imperfection employee effort equilibrium unemployment