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Employment protection
Christopher A. Pissarides ),1
Department of Economics, Centre for Economic Performance, London School of Economics and
CEPR, Houghton Street, London WC2A 2AE, UK
Abstract
Employment protection legislation is generally blamed for reducing labor turnover and
increasing the duration of unemployment. This paper argues that a proper evaluation of
employment protection requires a model where there is need for it. The model in this paper
gives an insurance role to employment protection in the absence of perfect insurance
markets. It is shown that there is a role for both severance payments and advance notice of
termination and that if they are chosen optimally, exogenous unemployment insurance does
not influence equilibrium employment. Simulations show that if employment protection is
chosen optimally, it does not reduce job creation when compared to an equilibrium without
it. q 2001 Published by Elsevier Science B.V.
Keywords: Employment protection; Labor turnover; Equilibrium employment
1. Introduction
The question of Alabor market flexibilityB has attracted a lot of attention in the
European policy debate. It is often blamed for the apparently poor performance of
European labor markets, when compared for example with the performance of the
US labor market. A popular view amongst policy commentators is that the rapid
technological change and increased integration of the worlds economies during
)
132
the last 25 years required fast structural change in the industrialized world.
Whereas the United States could rely on its flexible markets for the accommodation of this change, European countries suffered from anachronistic institutions
that slowed down changeleading to a large increase in unemployment, failure to
increase employment amongst AminorityB groups and failure to take advantage of
the technological revolution: the term AeurosclerosisB is often used to capture the
apparent European failure in this connection.2
Labor market institutions are not the only ones that are blamed for eurosclerosis
but they are certainly central to the argument. My objective in this paper is to take
one such institution, Aemployment protectionB, and investigate the economic
foundations of the argument that it has contributed to eurosclerosis. My analysis is
purely theoretical. One of my contentions is that much of the debate about
employment protection has been conducted within a framework that is not suitable
for a proper evaluation of its role in modern labor markets. I recommend a
framework for the conceptual and eventually empirical evaluation of employment
protection that is different from those in the literature, in the key sense that
employment protection has an economic role to play in the employeremployee
relationship.
The popular perception is that employment protection contributed to the failure
of European labor markets to adapt to new conditions, and the less of it there is,
the better. Amongst others, the OECDs Jobs Study 1994. encouraged its
members to increase the flexibility of their labor markets by reducing employment
protection, and the majority of countries have responded positively to this recommendation see OECD, 1999a.. But rigorous econometric testing has not been able
to conclude that employment protection has a big impact on labor market
performance. The OECD, in its recent thorough review of the evidence about the
influence of employment protection on labor market performance, concluded that
stricter employment protection does not appear to influence mean unemployment
rates or the ratio of employment to population OECD, 1999b.. There is some
weak evidence that it may marginally benefit prime-age male workers, at the
expense of all other groups youths, women, older men.. It also concluded that
stricter employment protection reduces labor turnover, with tenures in both jobs
and unemployment lasting longer. The most robust conclusion that it could reach,
however, is the seemingly unimportant one that stricter employment protection is
associated with more self-employment.3
2
Representative references where institutions and their implications for flexibility are discussed
include Layard et al. 1991., Bertola 1999., OECD 1994, 1999a,b., Nickell and Layard 1999.,
Mortensen and Pissarides 1999., Ljungqvist and Sargent 1998. and Blanchard 1999..
3
Although some authors claim that employment protection reduces employment, most recently, for
example Di Tella and MacCulloch 1999., the consensus view agrees with the OECD studys main
finding, i.e. that employment protection reduces labor turnover but has no appreciable influence on
mean unemployment.
133
This is very weak evidence of any harmful effects that employment protection
may have on labor market performance. Looking briefly at the impact on
self-employment, the explanation is that stricter employment protection laws
encourage more self-employment because self-employment is a way of avoiding
the employment protection regulations. But to my knowledge. no models of
self-employment have been developed and rigorously tested with a view to
establishing that the reason for the higher self-employment in countries with
stricter employment protection is indeed the stricter employment protection.
The traditional explanation for the other two findings, the differential impact on
prime-age men and the longer durations of both employment and unemployment,
is that employment protection reduces both employment terminations and job
creation. Empirically, it so happens that the balance shifts marginally in favor of
more employment for prime-age men but against the employment of all other
groups, who do not have sufficiently long job tenures to benefit from the
protection. Moreover, with fewer job terminations and less job creation, inflows
into and outflows from both employment and unemployment are lower.
The analysis of employment protection has been mostly conducted within a
framework that does not justify its existence. Exogenous policy on employment
protection is introduced into models of labor market equilibrium and the effects on
job creation, wage determination and job terminations are computed. In such a
framework it is hard to see any beneficial effects of employment protection,
beyond the obvious one of making jobs last longer. Even this, however, is not
beneficial if the match is unproductive. Yet, workers usually seek employment
protection and employers do not appear to oppose it as vigorously as some
economists do.4 Why?
In this paper I will take a different view of employment protection. I will
restrict myself to models that suggest a reason for the existence of employment
protection, the insurance of workers against income risk. This indeed must be the
reason that workers want employment protection. Firms do not oppose it because
by offering it to their employees, they are able to reduce the per-unit cost of labor,
either through higher productivity on efficiency-wage arguments or by reducing
mean wages for given productivity. It is also argued sometimes that employment
protection increases the incentives for workers and firms to engage in training in
firm-specific skills, but it is difficult to see why firms and workers will need
legislation to protect them from not wasting firm-specific skills. In contrast, there
are reasons for mandatory employment protection when the reason for it is job
For example, the Financial Times reported that the OECDs conclusion that employment protection
has no significant impact on unemployment Abrought protests from governments, congratulations from
trade unions, and uproar from the OECDs economics departmentB Robert Taylor reporting, July 10,
1999.. There was no mention of protests from employers organizations.
134
security, even though on ex ante grounds both firms and workers want the
employment protection.
In the presence of complete insurance markets, the need to insure workers
through employment protection does not arise. But perfect insurance markets in
the environment of my model cannot develop because of moral hazard. The
market response to the moral hazard is to introduce employment protection.
The advantage from working with this framework is that I can derive both the
optimal level of job protection and its effects on labor market performance within
the same framework. I show that the extent to which private insurance can be
bought, and the gap between income in work and unemployment insurance, are
important influences on employment protection.
The cost of providing additional income insurance through delayed dismissal is
that some jobs continue in operation, although on efficiency criteria they should be
destroyed. The common argument against employment protection made in the
literature, that it reduces new job creation, is not always supported. I show that
well-designed flexible employment protection does not reduce job creation, because it makes the total job package offered to the worker more attractive. But
purely administrative costs of employment terminations, which I do not consider,
almost certainly reduce both job creation and job destruction in my framework, as
in other models, since they make turnover more expensive.
I will make use of a model of search and matching under rational expectations
about the stochastic processes and policies that influence job creation, job destruction and labor turnover. The key new assumption is that workers are risk averse
and choose their strategies in order to maximize the lifetime utility of consumption. Firms are risk neutral because they are more diversified and have better
access to capital markets. If this is reminiscent of the static Aimplicit contract
theoryB of the 1970s it is intentionally so Azariadis, 1975; Baily, 1974; Gordon,
1974.. My two main theoretical results are dynamic generalizations of the two
main results of the static theory. The first main result of the static theory is the
celebrated Areal wage rigidity,B and the second the less celebrated Aover-employment.B The firm offers a contract that insures the worker against wage fluctuations
whilst employed and in the absence of severance payments. against employment
fluctuations in the event of large negative shocks.5 The insurance results that hold
in my model are similar to the results of the static theory, but in contrast to that
5
The Areal wage rigidityB result was in the original papers and it caused a lot of controversy ` and
confusionbecause it was mistakenly thought to provide a foundation for employment fluctuations
and rigid wages. In fact it provided reasons for the separation of the wage decision from the
employment decision, i.e. for a movement away from the labor demand curve. The over-employment
result was noted later. See Akerlof and Miyazaki 1980. and Pissarides 1981. for independent and
different demonstrations. For discussions of the literature that followed the original models see, e.g.
Hart 1983. and Rosen 1985..
135
theory, the important new result that I derive is closer to the over-employment
result than to the wage rigidity one.
Even in the presence of optimal severance payments, but in the absence of
perfect unemployment insurance, there are configurations of the parameters that
will make the firm want to keep the worker employed in unproductive jobs. The
extension of the employment contract, however, is not indefinite. An advance
Anotice of dismissalB will be given similar to the one that we find in employment
protection laws. Providing insurance through severance payments does not introduce deadweight costs but the insurance that can be provided is of limited value. It
insures the savings of employed workers against the employment hazard but it
cannot insure the savings of the unemployed against the unemployment hazard. An
advance notice of dismissal can provide additional income insurance. It has two
implications. It spreads employment income over a longer time horizon, by
lengthening the job tenure, and so endogenizes the gap between employment and
unemployment income; and secondly, it induces search on the job, and so it
introduces a positive probability that the worker will move from the current job to
a more productive one without the income loss associated with unemployment.
Both these implications provide additional insurance against income risk due to
job loss.
Equilibrium search models with non-linear utility are notoriously difficult to
solve analytically. The small number that have appeared in the literature have been
solved numerically Costain, 1995; Valdivia, 1995; Andolfatto and Gomme,
1996.. Although I will report some numerical results, one of the purposes of this
paper is to show how non-linear utility can be introduced into search models in
tractable ways.6
I will begin by looking at the types of employment protection regulations in
practice in industrial countries by drawing on the recent thorough study by the
OECD 1999b.. In Section 3 I define the market structure and in Section 4 I work
out the full solution when there is a complete set of insurance markets. I show why
moral hazard will prevent full insurance from developing. I then demonstrate, in
Section 5, how severance payments can be a perfect substitute for insurance
against the unemployment risk, enabling the worker to attain the same consumption profile whilst employed though not necessarily the same level. as with full
insurance. In Section 6 I show that dismissal delays can provide imperfect
insurance against the unemployment risk, i.e. the uncertainty over the duration of
unemployment. Finally, Sections 7 and 8 work out the implications of the model
for equilibrium job creation and job destruction. Some remarks on policy implications are collected in the concluding Section 9.
6
Similar arguments have recently been made for non-linear utility by Acemoglu and Shimer 1999..
Their rule for optimal unemployment insurance in their static framework. is similar to the rule that I
derive for optimal employment protection in a dynamic model.
136
137
Table 1
Employment protection legislation, late 1990s
Notice
months.
Severance
months pay.
Administrative
index 06.
Overall strictness
index 06.
Rank 121.
EU
Austria
Belgium
Denmark
Finland
France
Germany
Greece
Ireland
Italy
Netherlands
Portugal
Spain
Sweden
United Kingdom
EU average
1.5
2.9
3.0
2.4
2.4
1.6
1.5
0.6
1.1
2.0
2.7
1.0
3.5
1.0
1.9
2.0
0.0
0.0
0.0
0.4
0.0
1.0
0.2
3.5
0.0
4.0
2.6
0.0
0.5
1.0
3.0
1.6
1.7
2.5
2.7
3.4
2.6
2.0
3.0
3.9
3.9
2.7
3.6
1.0
2.7
2.3
2.5
1.5
2.1
2.8
2.6
3.5
1.1
3.4
2.2
3.7
3.1
2.6
0.9
2.5
12 16.
13 17.
08 05.
09 10.
17 14.
16 15.
20 .
05 12.
19 20.
10 09.
21 18.
18 19.
14 13.
02 07.
Others
Australia
Canada
Japan
New Zealand
Norway
Switzerland
United States
0.8
0.5
1.1
1.2
1.1
2.0
0.0
1.0
0.2
1.5
1.5
0.0
0.0
0.0
1.3
1.4
2.9
1.6
3.0
1.5
0.7
1.2
1.1
2.3
0.9
2.6
1.5
0.7
06 04.
04 03.
11 08.
03 02.
15 11.
07 06.
01 01.
Country
Source, OECD 1999b.. Notice period is the required length of advance notice of dismissal plus the
time needed for the notice to become effective, regular employment of at least 4 years tenure Table
2.2, p. 55.. Severance payment is the months salary due to dismissed regular employees of at least 4
years standing Table 2.2.. The administrative index is a weighted average of the index for procedural
inconveniences, difficulty of dismissal and difficulty of collective dismissals the first two with equal
weight and the third with 0.4 of the others; Tables 2.2 and 2.4.. The overall strictness index is the
OECDs summary index of all the indicators listed in the text for all workers Aversion 2B .. The rank in
brackets is the one reported for the late 1980s in the OECDs Jobs Study and not the one for the 1980s
updated in OECD, 1999a,b.. Source for both columns: OECD 1999b, Table 2.5, p. 66.. The updated
rank for the 1980s is virtually identical to the one for the 1990s.
138
severance payments and the administrative index I report only data for regular
employment of 4 years tenure. Only restrictions in legislation are reported; private
contracts often have their own clauses about severance payment and notice of
termination but data are difficult to get.7
The table shows a lot of variation in the strictness of employment protection
legislation, which according to the OECD has shown a lot of persistence between
the late 1980s and the late 1990s. In terms of overall strictness, the six countries
with the least restrictive legislation are the six English speaking countries in the
sample, headed by the United States and followed by the United Kingdom. The
four countries with the strictest protection are the four southern European countries, followed by France.
There are several notable variations in the types of employment protection
adopted. The requirement of minimum severance payment is more rare than the
requirement of notice, with some exceptions. For example Spain, one of the most
restrictive countries overall, requires only 1 month of notice after 4 years of job
tenure, but imposes very high severance payments. By contrast, Sweden requires
much longer notice but does not impose a minimum severance payment at all. Fig.
1 shows the administrative strictness index against the weighted sum of notice and
severance payment compiled by the OECD on a comparable 06 scale.. The
7
For example, the OECD reports that it is estimated in the United States that 1535% of employees
are covered by company severance payment plans OECD, 1999b, p. 58.. The OECD data also appear
to ignore recent changes in the US, which make it difficult to dismiss workers in some cases.
139
countries further away from the origin are the ones with more strict employment
protection. There is close correlation between the severance payment and notice
requirement on the one hand and the administrative cost of dismissal on the other.
The severance payment could also be made available if the worker quits during a notice period
without change in the results.
140
141
internalizes the search externalities Hosios, 1990; Pissarides, 2000, chapter 8..
Namely, the wage rate shares the surplus from the job according to the elasticity of
the constant-returns matching function with respect to unemployment. The same
rule is shown to hold here in the risk-neutral case, but the sharing rule generalizes
under risk aversion. The advantage of the competitive search assumptions, however, are mainly in the choice of the notice of termination, s. I show that if the
firm posts a wage rule, a severance payment and a notice period conditional on the
arrival of a bad shock, the severance and notice period that maximize the firms
profit correspond to the Pareto choices of the worker.
The choice with respect to job creation follows standard assumptions. Because
of frictions, the firm cannot fill its job instantaneously. A vacant job costs
something to maintain or create, with identical results. and firms create jobs up to
the point where the extra profit from one more job falls to zero. It is shown in
Pissarides 2000, chapter 3. that this assumption corresponds to the assumptions
underlying a dynamic labor demand curve with costs of employment adjustment.
Workers choose their consumption levels and whether to search for another job
or not is conditional on the parameters of the posted employment contract. I
assume that search intensity is fixed and do not make explicit the cost of search. I
assume instead that search takes place if the rewards from finding a new job are
strictly greater than the rewards currently available to the worker.
4. Consumption choices with full insurance
I assume throughout that the firm is risk neutral, but the worker is risk averse.
Her utility flow is denoted u c ., where c is consumption, and utility satisfies the
usual regularity conditions. During unemployment, utility at time t is given by
U t . s
Ht e
`
y d qa. t yt .
u c t . . q aW t . . dt ,
1.
where d is the rate of pure time preference, a is the rate at which unemployment
is given up for a job, and W t . is the expected lifetime utility at t when a job is
accepted. The latter satisfies
W t . s
Ht e
`
y d q l . zy t .
u c z . . q lWn z . . d z ,
2.
under the assumption that the worker changes from a productive to an unproductive job at the rate l. The expected lifetime utility from the unproductive job
satisfies
Wn z . s
Hz e
`
y d qaqs. tyz .
u c t . . q aW t . q sU t . . d t ,
3.
given that this state terminates for two reasons, when the worker quits to take a
productive job and when she is dismissed into unemployment.
142
The worker maximizes utility in each state by choosing the optimal consumption sequence subject to the budget constraints. We say that there is a full set of
insurance markets when the worker can buy annuities in each state that insure her
against the risk of income fluctuations, due to changes in wages or employment
status. The result is a consumption profile that depends on permanent income, the
average of income in employment and unemployment. Making the additional
assumption that the rate of interest is equal to the rate of time preference, r s d ,
we obtain that the consumption profile is flat throughout the infinite. horizon.
Appendix A derives this solution from a full set of insurance contracts.
Now let c be the flat consumption profile chosen. Substitution of c into the
lifetime utility functions and integration gives,
W s Wn s U s
u c .
r
4.
pywyR
rql
R q w q ss
rql rqaqs
5.
The second term in the right-hand side of Eq. 5. is the loss suffered because the
job is kept active during an unproductive period with the exception of the
severance payment, which has to be paid anyway.. It is maximized when s s 0,
when the job is destroyed only when the worker quits and minimized when s s `,
when the only cost of termination is the severance payment s . Setting the present
discounted value of profits in Eq. 5. equal to 0, we obtain the wage equation
ws
r q a q s . p y l ss
rqaqsql
6.
y R.
Wages fall in the premium paid for the severance payment and in the notice
period, because of the variable cost of the job. Substitution of Eq. 6. into the
consumption equation derived in Appendix A, Eq. 51., gives
cs
rqa
rqaql
p yR. q
l sb y r q a . R .
r q a q l. r q a q s .
7.
143
It follows from this analysis that neither severance payments nor notice of
termination have a role to play. Severance payments are irrelevant, as they can be
undone by private insurance markets. But the notice of termination makes the
equilibrium worse because it reduces income and consumption. Consumption
without a delay in dismissal s s `. is
r q a. p y R . q l b
.
8.
rqaql
With a complete set of insurance markets, the individual can arrange the income
from work in such a way as to maximize consumption.
cs
5. Severance payments
I discuss here the role of severance payments and in the next section. dismissal
delays in the absence of insurance markets, when the worker is given the freedom
to choose both subject to a zero-profit constraint on the value of the firm.
A severance payment is a transfer from the firm to the worker when the latter
joins unemployment. Generally, the worker wants to save during employment to
maintain her consumption level during unemployment. In the absence of insurance
markets, and because of the risk of the early arrival of a negative shock, the
worker will want to save a lot at first, but less as the job tenure rises and assets
accumulate. So the optimal consumption path during employment rises. The
severance payment acts as insurance against the employment risk: the worker pays
a premium in the form of a wage reduction, and the firm guarantees a payment on
termination that is independent of the duration of the job. The optimal payment is
chosen so that consumption during unemployment is maintained at a level that is
optimal when compared with the consumption level during employment.
Formally, the severance payment is a perfect substitute for insurance for
employed workers. The worker uses the firm as banker and insurer. To see this,
and also facilitate the discussion of dismissal delays in the next section, suppose
the worker does not have access to a capital market at all. The firm, however, has
full access. The worker chooses an optimal consumption profile and severance
payment and the firm finances this profile, by making wage payments that exactly
match, in each period, the chosen consumption.
Let A w t . be the net asset position that the worker implicitly has with the firm
during the productive phase of the job and A nt . the asset position at the start of
the unproductive phase of the job. The firm AreceivesB from the worker, during
the productive phase income flow p y R, makes a payment c t ., and can invest
the net position A w t . at the safe interest rate r. Hence, the evolution of the
workers net asset position with the firm under zero profits is
Aw t . s rA w q p y R y c t . q l A n t . y A w t . . ,
given that the state changes at rate l.
9.
144
EWn t .
E An t .
10 .
where now A n t . is the workers initial asset position with the firm when the
productive phase terminates.
In the unproductive phase, the firm again can earn r on the workers net asset
position, it now pays the variable cost R, it finances the workers consumption, it
pays severance s when the worker is dismissed at rate s . but does not pay if the
worker finds a job before dismissal at rate a.. Hence, under the zero-profit
constraint the workers net asset position evolves according to
An t . s rA n t . y R y c t . q aA n t . q s A n t . y s t . .
11 .
s uX c n . s
EU t .
Es t .
12 .
Combining the result in Eq. 12. with the result in Eq. 10., we find that when
there are optimal severance payments, the worker can maintain a flat consumption
profile throughout her tenure on the job: the firm pays the worker a fixed wage
and a lump sum when she is dismissed, and the worker does not need access to
either an insurance market or to a capital market. The firm can offer a perfect
substitute for each.
145
following on-the-job search; and it extends the length of time that the worker can
use the firm as a banker and insurer.
The results that I derive about dismissal delays are due to the drop in
consumption that takes place when the worker can no longer use her firm as
insurer. I derive the implications of no insurance here when in addition the
unemployed worker has no access to a capital market; i.e., when consumption is
identically equal to income. This restriction was of no consequence to the
preceding section; it is here, but facilitates the exposition and can help me make
the main point that I want to emphasize about the role of dismissal delays.9
Without assets, the utility flow during employment is u w t .., and during
unemployment, it is u b .. The choice variables are the wage profile " w t .4 and the
notice of termination s, given the constraint that jobs require compensation R per
period and given the arrival rates of new productive opportunities, a, and negative
shocks, l. Our assumption that the unemployed cannot save makes severance
payments uninteresting and they are not considered further.
As in the preceding section, I derive first the Pareto optimal choices with
respect to the wage profile and the dismissal probability under the assumption that
workers are risk averse and firms risk neutral. The Pareto allocations are chosen
by maximizing the employed workers lifetime utility subject to a zero profit
constraint on firms.
The present discounted value of profits for a job beginning at time 0 when
wages are not constant are
Js
H0 e
`
rq l .t
p y w t . y R q l Jn t . . d t
13 .
Ht e
`
y rqaqs. t yt .
w t . q R . dt .
14 .
15 .
It is hoped to work out the full solution with a capital market in future work. Preliminary findings
indicate that the main results discussed here are valid.
146
16 .
max W s.t. J G 0.
" w t .4 , s
Let m be a co-state variable associated with the constraint. Not surprisingly, the
Euler conditions with respect to the wage path confirm the results of the preceding
section. The wage path chosen is flat and satisfies
uX w . s m .
17 .
Rqw
rqaqs
18 .
u b . q aW
19 .
rqa
during unemployment,
Wn s
u w . q aW q sU
20 .
rqaqs
u w . q lWn
21 .
rql
when she is in a productive job. The bar on the W in Eqs. 19. and 20. indicates
that the utility is the one obtained in a new job that is not influenced by the
parameters of the contract in the present job although equilibrium will be
assumed to be symmetric..
The choice of termination period is restricted to a constant dismissal rate s,
which cannot be revised on the basis of experience during search on the job after
the arrival of the negative shock. When a worker first enters a job, she receives a
contract that specifies a stationary wage profile for an average of 1rl q 1rs
periods, with s chosen optimally, and no revisions are made to the contract. The
choice of s maximizes Eq. 20. subject to Eq. 15. and so is governed by the sign
of EWnrEs q m E JnrEs, which at the stationary w satisfies
EWn
Es
qm
E Jn
Es
r q a . U y u w . y aW q m w q R .
r qa qs.
22 .
147
qm
E Jn
Es
u b . y u w . q uX w . w q R .
r qa qs.
23 .
The constraint 15. will hold as equality at the maximization point, giving the
optimal wage level as
rqaqs
ws
p y R.
24 .
rqlqaqs
Note that at s s 0, when the job is never terminated,
rqa
w0 s
pyR
rqlqa
25 .
26 .
w` s p y R.
u w .
27 .
and the equilibrium is trivial because no one has an incentive to search for a
productive job. If Eq. 23. is positive at all s G 0, we therefore arbitrarily fix s at
some low positive value. We will, however, be interested in parameter ranges that
imply that if s is finite, it is an interior maximum. For a nonzero s, utility
functions in symmetric equilibrium satisfy
W y Wn s
s u w . y u b .
r q a q l. r q a q s .
28 .
and
Wn y U s
u w . y u b .
rqaqs
29 .
so w ) b is sufficient to ensure that the incentives for search for another job,
either when unemployed or employed in an unproductive job, are present. Fig. 2
shows the path of income when no notice is given and when it is given. When
notice is given the wage falls, as shown in Eq. 24., and so the gap between
income in work and income out of work is reduced. Also, for given duration of
search, the time that the individual spends in unemployment, when income and
consumption are lower, is reduced. We will see shortly that the optimal notice
period is one that achieves an optimal relation between the wage rate and
unemployment benefit, given that the longer the notice period is, the lower the
wage rate becomes.
148
Notice period is given if Eq. 23. vanishes at some finite s and it is not given if
Eq. 23. is positive at all finite s. Making use of Eqs. 23. and 24. we define the
function
f s;. . ' u b . y u w . q uX w . w q R . ,
30 .
with w defined by Eq. 24.. Clearly, if u.. is linear f s;.. is always positive,
confirming that no notice is given. Notice of dismissal is given only because of its
insurance properties. Table 2 reports some numerical results for the optimality of a
Table 2
Values of the replacement ratio below which it is optimal to give notice
Rr p
rma x
0
0.5
0.5
1
1
1.5
1.5
2
2
5
5
0.0
0.0
0.3
0.0
0.3
0.0
0.3
0.0
0.3
0.0
0.3
0.00
0.25
0.08
0.37
0.24
0.44
0.34
0.50
0.41
0.67
0.62
g is the constant coefficient of relative risk aversion, R r p is the cost of running the job per units of
output and r is the ratio of unemployment compensation to the wage rate.
149
finite s. I show the range of the replacement ratio, defined by brw ' r , for which
the sign of f s;.. is negative at s s `. The exercise is conducted for a constantrelativerisk-aversion utility function
us
w 1y g
1yg
31 .
Since for this utility function, f s;.. is monotonically increasing in r , I find the
value of r that implies f `, r . s 0. Any value of r below this critical value
implies that the optimal s is finite. I denote the critical value of the replacement
ratio by rmax . This is given by
rmax s
g y Rrp
1 y Rrp
1r 1y g .
32 .
The table shows the range of r for two values of the variable cost of keeping
the job active, 0 and 0.3. In the latter case the cost of giving notice is higher so
workers need a lower replacement ratio to induce them to stay on the job after it
becomes unproductive. The first line of the table confirms that if there is no risk
aversion, the job is always destroyed when it becomes unproductive. Small
degrees of risk aversion require only modest unemployment income to induce
firing but once the degree of risk aversion becomes large, even generous unemployment insurance is consistent with a notice period.
The properties of the optimal notice period defined by 1rs . can be derived
from Eq. 30.. The three main influences are already apparent in Table 2. The key
result is that giving advance notice is optimal only if the individual needs
insurance; i.e. if she is risk averse and unemployment insurance is insufficient.10
Other influences on the notice period can be derived from the equilibrium value of
the wage rate in Eq. 24..
7. Search equilibrium
We have so far specified the returns of the employer and worker from a job for
given arrival rate of jobs. The job destruction rules can be derived from the
analysis so far. A fraction of unproductive jobs is destroyed each period. If
productive employment is e and unproductive n, in a steady state the equality
l e s sn holds. Job destruction is given by sn and the job destruction rate by
snr n q e ., which, given that n s l ers, is equal to l sr l q s .. Thus, faster
Boeri et al. 2000. find some evidence of a trade-off between the generosity of unemployment
insurance and the strictness of employment protection a sub-sample of OECD countries.
10
150
arrival of negative shocks or shorter notice periods lead to more job destruction.
The commonly made assertion that employment protection low s . reduces job
destruction holds.
I now close the model by analyzing job creation. In order to derive job creation,
I study a model with wage posting and search frictions, similar to the one studied
by Moen 1997. but with infinite horizons.
Suppose a firm i in this market has a vacancy to fill. It posts a wage rate wi t .
and a dismissal rate si , conditional on the arrival of a negative shock, an event that
takes place at rate l. Given this posting a number of workers apply to the firm for
the job. Let the ratio of the pool of vacant jobs that post this contract to the pool of
applicants be denoted by u i , referred to as the tightness of market i. Some of these
applicants may be suitable and some not. I assume that the rate of success for each
job vacancy i is given by a constant-returns matching function, which defines a
rate of arrival of workers to vacant jobs q u i ., with qX u i . F 0 and elasticity
yh g 0, 1., assumed for convenience to be constant in the neighborhood of
equilibrium.11
A search equilibrium is defined as a wage rule, a termination rule and a market
tightness. I will derive the symmetric equilibrium where all firms offer the same
wage and termination rule and the tightness of each is equal to the market average.
Job applicants allocate themselves to each pool in such a way that no one can
be made better off by changing pool. A worker allocating herself to pool i will
match to a job at rate u i q u i ., an implication of the matching technology. The
expected returns of this worker from joining pool i generally depend on whether
the worker is unemployed or employed on notice of dismissal. I will work out the
solution when the firm posts a wage to attract unemployed job applicants. The
solution is not qualitatively different if it aimed its offer at employed job
applicants, a point discussed briefly in footnote 12.
The expected returns of the unemployed applicant are given by Ui , calculated
from Eqs. 1. 3. when the consumption flow during employment is equal to the
posted wage wi t ., the dismissal rate is s s si , and the arrival rate of jobs is
a s u i q u i .. Let U be the returns from joining the pool with the most attractive
posted contract. Then the constraint facing firm i is
Ui G U.
33 .
The firm is assumed to select the posted wage and the dismissal probability by
maximizing the PDV of profits from vacant jobs subject to Eq. 33..
Vacant jobs can enter the market at any time to participate in the matching
game. Let Vi be the expected profits from joining pool i with a vacant job. I
assume that creating the vacant job is costless but maintaining it open and
See Pissarides 2000, Chap. 1. for further discussion of the theory behind these assumptions and
Petrongolo and Pissarides 2000. for discussion of the matching function.
11
151
participating in the matching game costs k per period. The value of the vacancy
therefore satisfies
rVi s yk q q u i . Ji y Vi . ,
34 .
with Ji denoting the expected profit from a filled job that belongs to pool i. The
firm posts the wage contract that maximizes the value Vi .
Now, given our assumptions of risk-neutral firms and risk-averse workers, and
our previous results about the optimality of the flat wage profile, the firm will
choose to post a flat wage profile. I simplify the derivation of the search
equilibrium by imposing the flat profile from the outset and so define the
maximization program as
max Vi s
yk q q u i . Ji
r q q ui .
wi , s i , u i
p y wi y R
Ji s
rql
35 .
,
R q wi
36 .
r q l r q a q si
subject to
u b . q u i q u i . Wi
Ui s
r q ui q ui .
Wi s
u wi .
rql
37 .
G U,
u wi . q aW q sU
rql
rqaqs
38 .
The transition rates to jobs after the termination of job i and the expected returns
from such transitions are unspecified for the moment.
Maximization with respect to wi and u i gives the rules
y
y
q ui .
r q q ui . r q l
qX u i . Ji y Vi .
r q q ui .
qm
qm
ui q ui .
uX wi .
r q ui q ui . r q l
q ui . 1 y h .
r q ui q ui .
s 0,
Wi y Ui . s 0,
39 .
40 .
152
For a linear utility function, this rule internalizes the search externalities. Maximization with respect to si gives the following condition for an interior solution
q ui .
R q wi
r q q u i . r q l. r q a q s . 2
qm
ui q ui .
r q a . U y aW y u wi .
r q ui q ui .
r q l. r q a q s .
s0.
42 .
43 .
Conditions 41. and 43. are solved for the firms wage rate and optimal
dismissal policy, given the tightness of its market u i . Tightness is derived from the
search constraint 37., which holds as equality. In order to solve for tightness, we
need to know the value taken by U, the maximum expected return to the worker
from search. I close the model by assuming that the aggregate equilibrium is
symmetric, i.e. by writing w s wi , W s Wi and U s Ui . This, however, tells us
that tightness is the same in all sub-markets, not what it is. In order to derive the
value taken by tightness I impose the usual zero-profit condition on new job
creation; i.e. I assume that firms will create vacant jobs up to the point where all
rents from job creation are exhausted. This gives Vi s 0 for all i. Noting
conditions 34. and 36. and the symmetric equilibrium we derive the job creation
condition
py
rqsqlqu q u .
rqsqu q u .
w qR. s
r q l. k
.
q u .
44 .
The right-hand side of Eq. 44. is the expected cost of recruiting a worker and the
left hand-side for s s ` is the net revenue from this worker, p y w q R .. Thus,
Eq. 44. is a generalized demand for labor curve, which equates net revenue to
costs when there is a notice period.
Recall that three unknowns fully define the search equilibrium, w, s, u . The
three equations that give their solutions are Eqs. 41., 43. and 44.. We make use
of Eqs. 28., 29. and 35. for V s 0 to substitute the value functions out of Eq.
41.. The result is the new sharing equation
u w . y u b .
u w.
X
r q u q u . q l. r q u q u . q s .
.
rqsqu q u . ql
1yh . q u .
hk
45 .
153
Eqs. 43. 45. give unique solutions for w, s and u . Eq. 43. determines wages.
With wages given, Eq. 44. gives a positively sloped relation between s and u and
Eq. 45. gives a negatively sloped relation. Their intersection point is the
equilibrium solution for s and u .
8. The role of employment protection
A numerical illustration of the equilibrium solution is shown in Table 3. The
solution is worked out for an implied mean recruitment cost of 5% of expected
output. The implied mean duration of search is 2.7 months and mean duration of
notice 1.7 months. In the case where no notice is given, the mean duration of
unemployment is 2.7 months but in the case where notice is given it is 1 month.
The employment and unemployment rates are calculated by equating flows in and
out of each stock. The results of the table show that the notice period does not
affect the productive employment rate. If notice is not given, those on notice,
about 2% of the labor force, become unemployed, wages rise with virtually no
other change. Since workers are risk averse, they are made worse off by this
change. Unemployment and its duration are much higher in the absence of notice.
Equilibrium satisfies some strong properties with respect to the policy parameters. Making use of the insurance condition 43. to substitute wages out of Eq.
45., and then combine Eqs. 44. and 45., we obtain
h
k
ps
.
46 .
r q u q u . q l. q r q l
1yh
q u .
Table 3
Numerical illustration of the search equilibrium
Equilibrium solution
w
br w
k r q .r pr l.
1ru q
1r s
e
n
u
With notice
Without notice
0.920
0.500
0.050
0.225
0.142
0.947
0.020
0.033
0.939
0.490
0.051
0.221
0.000
0.948
0.000
0.052
154
creation is given by u q u .1 y e ., the fraction of job seekers who find jobs. Recall
that e is the rate of productive employment, and the implication of Eq. 46. is that
if the notice period is chosen optimally, the policy parameters do not influence job
creation.
In order to illustrate further this property, I consider the properties of equilibrium in a diagram with the length of notice the inverse of s . on the vertical axis
and u on the horizontal Fig. 3.. Eq. 46. is shown as a vertical line and labelled
Aequilibrium locusB. Eq. 44. implies a negative relation between 1rs and u : in a
partial context, the longer the notice required, the lower the job creation. This
curve is shown in Fig. 3 as a downward-sloping Ajob creation curve.B Now, an
increase in unemployment benefit increases wages through the insurance condition
43. and so shifts the job creation curve down. It does not change the other curve
in the figure. The final equilibrium is one of higher wages not shown., shorter
advance notification of dismissal and the same job creation.
Unemployment insurance does not influence job creation, despite the fact that it
increases wages, because of the fall in the notice period, which offsets the higher
wage costs. This illustrates an important point: employment protection and unemployment insurance are closely linked, and giving more of one and less of the
other can neutralize the effects on job creation.
In order to show that the model with exogenous protection replicates the results
obtained in the literature, suppose we fix s arbitrarily and study the job creation
wage equilibrium. In Fig. 4, I plot Eqs. 44. and 45., labelled Awage curveB and
Ajob creation curveB respectively, and show the unique equilibrium u ) , w ) .
Higher unemployment insurance increases wages as before, by shifting the wage
curve up, but because the notification requirement is held fixed, equilibrium
moves up the job creation curve, leading to less job creation.
Fig. 3. Effects of higher unemployment insurance when the notice period is optimal.
155
Fig. 4. Effects of higher unemployment insurance when the notice period is exogenous.
156
unproductive phase of a job. Although the overall effects on job creation are not
clear from the diagram alone, it can be shown by differentiation that job creation
increases at least for large s .. Thus, if employment protection is not optimally set,
less stringent employment protection increases both job creation and job destruction, as in conventional models.
9. Conclusions
I have argued that the models used to evaluate employment protection legislation are not usually models that justify the existence of the legislation and so they
are not appropriate for a full evaluation. I demonstrated that employment protection can provide insurance against income risk, when moral hazard or other
problems prevent unemployment insurance from providing sufficient cover. Severance payments can provide perfect insurance against the uncertainty of the
duration of a job the unemployment risk.. Dismissal delays reduce the mean
length of time that the worker spends unemployed and make it possible to choose
the gap between income in work and income out of work. I conclude by
suggesting some policy implications of the analysis.
The first question that needs addressing is why should the government be
needed to legislate employment protection measures and not leave it to private
contracts. This is not a question that I investigated so I cannot give a complete
answer. But under the employment protection rules that I derived, the worker pays
for the protection in the form of a lower wage rate for the duration of the
productive phase of the job and is compensated with higher income when the job
is no longer productive and dismissal becomes imminent. One can easily argue
that the firm will have incentives to default on its obligations and terminate the
contract without compensating the worker. Of course, with written employment
contracts, a defaulting firm can be taken to court. But the transfers involved are
usually small and if the courts are expensive this is not a realistic option.
Legislation can provide a cheaper alternative of enforcing rules that would be
optimal in private contracts.
In principle, the government can replicate private contracts. But I have shown
that the employment protection in private contracts is chosen as part of a package
of measures, and when shocks take place the employment protection is changed
along with wages and other features of the contract. Without this flexibility in the
protection legislation, the measures may alter the relative bargaining powers of
established workers and employers, and alter wages and job creation. Employment
protection may then have the kind of implications for the functioning of labor
markets that have been discussed in the literature: established workers gaining
power relative to others, job tenures increasing and job creation suffering.
The unemployment insurance and employment protection regimes are closely
inter-twined. If the government could legislate optimal unemployment insurance,
157
there would be no need for employment protection. The question why it is easier
to legislate employment protection than unemployment insurance, at least in some
countries, is a difficult one that we cannot address with the model of this paper
because it does not have a model of unemployment insurance.. The costs of
introducing and running an unemployment insurance scheme will have to be taken
into account if the relative merits of the two ways of providing insurance are to be
compared. A gain from unemployment insurance, however, that is not usually
mentioned in the policy debate but emerges out of our analysis, is that in countries
with poor unemployment insurance provision and strict employment protection
measures the southern European states being a good example., making unemployment insurance more generous can have an additional efficiency gain: the dismantling of expensive firing procedures, and the faster destruction of unproductive
jobs.
Appendix A
We derive here the optimal consumption with a full set of insurance markets.
Suppose that there is an insurance company that has access to a capital market
characterized by the unique interest rate r and that can pool resources to insure
against the risk of income fluctuation. Let the worker deposit her assets with this
insurance company and let the assets of the unemployed worker at some time t be
A u t .. The insurance company offers a contract which pays a rate of return b
during unemployment and a lump sum A w0 when the worker finds a job but gets
to keep the accumulated deposit A u t . The rate of return b is calculated from
actuarial fairness. In a short time period d t the insurance company earns rd t on
the workers assets and runs a risk ad t of making a net transfer A w0 y A u .. It
pays b d t for the duration of the contract, so actuarial fairness requires
b A u s rA u y a A w 0 y A u . .
47 .
48 .
with initial condition A u0. s A u0 q s , given that the unemployed worker receives severance payment s .
The budget constraint of employed workers is calculated in similar fashion. The
worker on notice deposits assets A n with the insurance company and gets A u0 if
she becomes unemployed or AXw0 if she becomes directly employed, both of which
are choice variables. She also gets severance payment s if she becomes unemployed. Her budget constraint satisfies
An s r q a q s . A n y aAXw 0 y sA u 0 q w y c,
49 .
with initial condition A n0. s A n0 . The initial condition is chosen by the worker
employed in a productive job, who deposits assets A w and gets back from the
158
50 .
with initial condition A w 0. s A w0 if the worker came to the job via unemployment or A w 0. s AXw0 if she came to it from another job after giving notice of
termination.
Maximization of lifetime utility with respect to consumption and asset holdings,
given some initial asset position, gives the optimal consumption path. In fact, not
all asset positions are needed to achieve maximum utility. The way the insurance
contract works is that the worker deposits an initial asset with the insurance
company and chooses the terminal asset payout so as to achieve the desired
consumption sequence between the two dates. Since the worker rotates between
employment and unemployment, both initial and terminal asset positions are
choice variables. There is an infinite number of initial and terminal asset positions
that can support the same consumption path in-between. We can therefore set
arbitrarily initial assets at some level, e.g. 0, and derive the optimal asset positions
from there onward. What is of interest to us here, however, is not the asset
positions per se but the fact that with the full set of insurance contracts described
in Eqs. 48. and 49., there is a unique consumption path that maximizes the
utility functions 1. 3. and which, for r s d , is stationary. We will make the
assumption r s d and therefore write simply c for the maximizing constant
consumption level. For a constant wage rate w an innocuous assumption in this
context., the optimal consumption level can be shown to be
cs
r q a. r q s q a q l. w q l s b q r q a. s .
r q a q l. r q a q s .
51 .
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