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A psychological contract, a concept developed in contemporary research by organizational scholar Denise Rousseau, represents the mutual beliefs, perceptions, and informal obligations between an employer and an employee. It sets the dynamics for the relationship and defines the detailed practically of the work to be done. It is distinguishable from the formal written contract of employment which, for the most part, only identifies mutual duties and responsibilities in a generalized form.

Although Rousseau's 1989 article as highlighted by Coyle-Shapiro "was very influential in guiding contemporary research", the concept of psychological contract was first introduced by Argyris (1960) - "Since the foremen realize the employees in this system will tend to produce optimally under passive leadership, and since the employees agree, a relationship may be hypothesized to evolve between the employees and the foremen which might be called the "psychological work contract." The employee will maintain the high production, low grievances, etc., if the foremen guarantee and respect the norms of the employee informal culture (i.e., let the employees alone, make certain they make adequate wages, and have secure jobs)".

History
As commercial organizations grew in size and complexity, there was a tendency to standardize than the individualize the treatment of labor. Trade unions emerged to offer protection to ever larger groups of employees. The result was collective bargaining to define pay and conditions by reference to grades across industries and trades, and in public service. More recently, unions have lost some of their significance, leaving employees in more direct control. But societies have developed expectations of a better work-life balance, reinforced by legislation, and employers have found it in their own best interests to develop practices that respect equal opportunities and employment rights through professionalized human resource services
 * the workforce has become more feminized;
 * the workforce is better educated, less deferential to authority and less likely to remain loyal;
 * the workforce is required to be more flexible to meet new challenges quickly and effectively, but this need to change can be a source of insecurity;
 * the use of temporary workers as well as outsourcing of projects and whole business functions also changes workers' expectations as to what they want to get out of their psychological contracts (e.g., transferable skills now vs. life-time employment before); and
 * automation has both empowered a greater percentage of the workforce and allowed the emergence of teleworking which fragments the old social orders of a single location workplace and generates greater freedom and flexibility in an ever increasing global workforce.

The formation of the contract
During the recruitment process, the employer and interviewee will discuss what they each can offer in the prospective relationship. If agreement is reached, most employers will impose a standard form contract, leaving the detail of the employee's duties to be clarified "on the job". But some of the initial statements, no matter how informal and imprecise, may later be remembered as promises and give rise to expectations. Whether they are incorporated into the parallel psychological contract will depend on whether both parties believe that they should be treated as part of the relationship. The better organized employers are careful to document offers to reduce the risk of raising false expectations followed by disappointment.

In the Common Law jurisdictions, the law implies duties requiring the employees to be loyal and trustworthy. These are imprecise in their definition and uncertain in much of their operation. But, in psychological terms, issues as to whether promises and expectations have been kept and met, and whether the resulting arrangements are fair, are fundamental to the trust between the employee and the employer. The first year of employment is critical as actual performance by the employee can be measured against claims and promises made during the interview, and the management has begun to establish a track record in its relationship with the employee at supervisor and manager level. Feldheim (1999) reflects these two strands by dividing the psychological contract into:
 * transactional: this is the economic or monetary base with clear expectations that the organization will fairly compensate the performance delivered and punish inadequate or inappropriate acts; and
 * relational: this is a socio-emotional base that underlies expectations of shared ideals and values, and respect and support in the interpersonal relationships.

The employment relationship develops
The reality of employment rights and duties emerges through the interpersonal relationships formed in the workplace. How employers, supervisors and managers behave on a day-to-day basis is not determined by the legal contract. Employees slowly negotiate what they must do to satisfy their side of the bargain, and what they can expect in return. This negotiation is sometimes explicit, e.g. in appraisal or performance review sessions, but it more often takes the form of behavioral action and reaction through which the parties explore and draw the boundaries of mutual expectation. Hence, the psychological contract determines what the parties will, or will not do and how it will be done. When the parties' expectations match each other, performance is likely to be good and satisfaction levels will be high. So long as the values and loyalty persist, trust and commitment will be maintained. The map followed by the parties is the development of an individualized career path that makes only reasonable demands on the employee, with adequate support from managers and co-workers, for a level of remuneration that is demonstrably fair for a person of that age, educational background, and experience. Motivation and commitment will be enhanced if transfers and promotions follow the agreed path in a timely fashion.

If managed effectively, the relationship will foster mutual trust between the parties, matching the objectives and commitments of the organization to those of their employees. But a negative psychological contract can result in employees becoming disenchanted, demotivated and resentful of authoritarianism within the organization. This will result in an increasingly inefficient workforce whose objectives no longer correspond to the organization they work for. The main cause of disappointment tends to be that middle managers are protective of their status and security in the eyes of their superiors, and this can introduce conflicts of interest when they are required to fulfill their obligations to their subordinates.

Breach
Psychological contract breach may occur if employees perceive that their firm, or its agents, have failed to deliver on what they perceive was promised, or vice versa. Employees or employers who perceive a breach are likely to respond negatively. Responses may occur in the form of reduced loyalty, commitment, and organizational citizenship behaviors. Perceptions that once psychological contract has been breached may arise shortly after the employee joins the company or even after years of satisfactory service. The impact may be localized and contained, but if morale is more generally affected, the performance of the organization may be diminished. Further, if the activities of the organization are perceived as being unjust or immoral, e.g. aggressive downsizing or outsourcing causing significant unemployment, its public reputation and brand image may also be damaged.

Manager–subordinate mismatch may also cause a breach of the psychological contract.