The Endogeneity of Employment Adjustment Costs: The Tradeoff between Efficiency and Flexibility

Abstract

This paper models a firm's choice of employment adjustment costs as one component of its choice of production process. In making a one-time choice of production process, firms trade off increased flexibility--the reduced cost of changing levels of production--against the diminished efficiency of producing a given level of output. The model predicts that firms facing greater volatility in expected employment choose production processes that entail relatively low costs of adjusting employment. Using estimates of adjustment costs and employment volatility for four-digit manufacturing industries, the paper finds empirical support for the model: Among four-digit industries facing similar choices of production process, those with more volatile employment tend to have lower costs of adjusting employment. Moreover, the paper finds that inter-industry heterogeneity in the amplitude of deterministic seasonal fluctuations in employment is more important than the variance of stochastic employment fluctuations in explaining the choice of adjustment costs.

JEL Classification: J23, E23, L16, L23