Pareto-Improving Firing Costs?
49 Pages Posted: 28 Jan 2011 Last revised: 1 Aug 2011
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: Suggested Citation