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Description:
We analyze the impact of imperfect contract enforcement on the emergence of unemployment. In an experimental labor market where trading parties can form long-term employment relationships, we compare a work environment where effort is observable, but not verifiable to a situation where explicit contracts are feasible. Our main result shows that unemployment is much higher when third-party contract enforcement is absent. Unemployment is involuntary, being caused by firms' employment and contracting policy. Moreover, we show that implicit contracting can lead to a segmentation of the labor market. Firms in both segments earn similar profits, but workers in the secondary sector face much less favorable conditions than their counterparts in primary-sector jobs.