Pareto-Improving Firing Costs?

49 Pages Posted: 28 Jan 2011 Last revised: 1 Aug 2011

See all articles by Bilgehan Karabay

Bilgehan Karabay

RMIT University, School of Economics, Finance and Marketing

John McLaren

University of Virginia; NBER

Date Written: January 28, 2011


We examine self-enforcing contracts between risk-averse workers and risk-neutral firms (the ‘invisible handshake’) in a labor market with search frictions. Employers promise as much wage smoothing as they can, consistent with incentive conditions that ensure they will not renege during low-profitability times. Equilibrium is inefficient if these incentive constraints bind, with risky wages for workers and a risk premium that employers must pay. Mandatory firing costs can help, by making it easier for employers to promise credibly not to cut wages in low-profitability periods. We show that firing costs are more likely to be Pareto-improving if they are not severance payments, or (for affluent economies) if the economy is open.

Keywords: Implicit Contracts, Invisible Handshake, Firing Costs

JEL Classification: F10, F16, J63

Suggested Citation

Karabay, Bilgehan and McLaren, John, Pareto-Improving Firing Costs? (January 28, 2011). Available at SSRN: or

Bilgehan Karabay

RMIT University, School of Economics, Finance and Marketing ( email )

445 Swanston Street.
Bld. 80, Level 11
Melbourne, 3000

John McLaren (Contact Author)

University of Virginia ( email )

P.O. Box 400182
Charlottesville, VA 22904-4182
United States
434-924-3994 (Phone)
434-982-2904 (Fax)


1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Here is the Coronavirus
related research on SSRN

Paper statistics

Abstract Views
PlumX Metrics