1-s2.0-S092753710100032X-main

.Labour Economics 8 2001 131159www.elsevier.nlrlocatereconbase

Employment protectionChristopher A. Pissarides) ,1

Department of Economics, Centre for Economic Performance, London School of Economics andCEPR, Houghton Street, London WC2A 2AE, UK

Abstract

Employment protection legislation is generally blamed for reducing labor turnover andincreasing the duration of unemployment. This paper argues that a proper evaluation ofemployment protection requires a model where there is need for it. The model in this papergives an insurance role to employment protection in the absence of perfect insurancemarkets. It is shown that there is a role for both severance payments and advance notice oftermination and that if they are chosen optimally, exogenous unemployment insurance doesnot influence equilibrium employment. Simulations show that if employment protection ischosen optimally, it does not reduce job creation when compared to an equilibrium withoutit. 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 theEuropean policy debate. It is often blamed for the apparently poor performance ofEuropean labor markets, when compared for example with the performance of theUS labor market. A popular view amongst policy commentators is that the rapidtechnological change and increased integration of the worlds economies during

) Tel.: q44-2079557513; fax: q44-2079557866. .E-mail address: [email protected] C.A. Pissarides .

1 The Adam Smith Lecture, delivered at the first SOLErEALE World Conference, 2225 June2000, The Catholic University of the Sacred Heart, Milan, Italy. I have benefited from conversationswith, among others, Tito Boeri, Pietro Garibaldi, Maia Guell, Dan Hamermesh, Ed Lazear, DaleMortensen and Etienne Wasmer and from the detailed comments of Melvyn Coles. Financial supportfor the Adam Smith lecture was provided by Dubois Chartered Accountants, Amsterdam.

0927-5371r01r$ - see front matter q2001 Published by Elsevier Science B.V. .PII: S0927-5371 01 00032-X

( )C.A. PissaridesrLabour Economics 8 2001 131159132

the last 25 years required fast structural change in the industrialized world.Whereas the United States could rely on its flexible markets for the accommoda-tion of this change, European countries suffered from anachronistic institutionsthat slowed down changeleading to a large increase in unemployment, failure toincrease employment amongst AminorityB groups and failure to take advantage ofthe technological revolution: the term AeurosclerosisB is often used to capture theapparent European failure in this connection.2Labor 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 takeone such institution, Aemployment protectionB, and investigate the economicfoundations of the argument that it has contributed to eurosclerosis. My analysis ispurely theoretical. One of my contentions is that much of the debate aboutemployment protection has been conducted within a framework that is not suitablefor a proper evaluation of its role in modern labor markets. I recommend aframework for the conceptual and eventually empirical evaluation of employmentprotection that is different from those in the literature, in the key sense thatemployment protection has an economic role to play in the employeremployeerelationship.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 employmentprotection, and the majority of countries have responded positively to this recom-

.mendation see OECD, 1999a . But rigorous econometric testing has not been ableto conclude that employment protection has a big impact on labor marketperformance. The OECD, in its recent thorough review of the evidence about theinfluence of employment protection on labor market performance, concluded thatstricter employment protection does not appear to influence mean unemployment

.rates or the ratio of employment to population OECD, 1999b . There is someweak evidence that it may marginally benefit prime-age male workers, at the

.expense of all other groups youths, women, older men . It also concluded thatstricter employment protection reduces labor turnover, with tenures in both jobsand unemployment lasting longer. The most robust conclusion that it could reach,however, is the seemingly unimportant one that stricter employment protection isassociated 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 mainfinding, i.e. that employment protection reduces labor turnover but has no appreciable influence onmean unemployment.

( )C.A. PissaridesrLabour Economics 8 2001 131159 133

This is very weak evidence of any harmful effects that employment protectionmay have on labor market performance. Looking briefly at the impact onself-employment, the explanation is that stricter employment protection lawsencourage more self-employment because self-employment is a way of avoiding

.the employment protection regulations. But to my knowledge no models ofself-employment have been developed and rigorously tested with a view toestablishing that the reason for the higher self-employment in countries withstricter 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 jobcreation. Empirically, it so happens that the balance shifts marginally in favor ofmore employment for prime-age men but against the employment of all othergroups, who do not have sufficiently long job tenures to benefit from theprotection. Moreover, with fewer job terminations and less job creation, inflowsinto 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 employmentprotection is introduced into models of labor market equilibrium and the effects onjob creation, wage determination and job terminations are computed. In such aframework it is hard to see any beneficial effects of employment protection,beyond the obvious one of making jobs last longer. Even this, however, is notbeneficial if the match is unproductive. Yet, workers usually seek employmentprotection and employers do not appear to oppose it as vigorously as someeconomists 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 employmentprotection, the insurance of workers against income risk. This indeed must be thereason that workers want employment protection. Firms do not oppose it becauseby 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 reducingmean wages for given productivity. It is also argued sometimes that employmentprotection increases the incentives for workers and firms to engage in training infirm-specific skills, but it is difficult to see why firms and workers will needlegislation to protect them from not wasting firm-specific skills. In contrast, thereare reasons for mandatory employment protection when the reason for it is job

4 For example, the Financial Times reported that the OECDs conclusion that employment protectionhas 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.


security, even though on ex ante grounds both firms and workers want theemployment protection.In the presence of complete insurance markets, the need to insure workers

through employment protection does not arise. But perfect insurance markets inthe environment of my model cannot develop because of moral hazard. Themarket 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 withinthe same framework. I show that the extent to which private insurance can bebought, and the gap between income in work and unemployment insurance, areimportant 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 bedestroyed. The common argument against employment protection made in theliterature, that it reduces new job creation, is not always supported. I show thatwell-designed flexible employment protection does not reduce job creation, be-cause it makes the total job package offered to the worker more attractive. Butpurely administrative costs of employment terminations, which I do not consider,almost certainly reduce both job creation and job destruction in my framework, asin 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 destruc-tion and labor turnover. The key new assumption is that workers are risk averseand choose their strategies in order to maximize the lifetime utility of consump-tion. Firms are risk neutral because they are more diversified and have betteraccess 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 thecelebrated Areal wage rigidity,B and the second the less celebrated Aover-employ-ment.B The firm offers a contract that insures the worker against wage fluctuations

.whilst employed and in the absence of severance payments against employmentfluctuations in the event of large negative shocks.5 The insurance results that holdin 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 andconfusionbecause it was mistakenly thought to provide a foundation for employment fluctuationsand rigid wages. In fact it provided reasons for the separation of the wage decision from theemployment 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 anddifferent demonstrations. For discussions of the literature that followed the original models see, e.g.

. .Hart 1983 and Rosen 1985 .


theory, the important new result that I derive is closer to the over-employmentresult 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 thatwill make the firm want to keep the worker employed in unproductive jobs. Theextension of the employment contract, however, is not indefinite. An advanceAnotice of dismissalB will be given similar to the one that we find in employmentprotection laws. Providing insurance through severance payments does not intro-duce deadweight costs but the insurance that can be provided is of limited value. Itinsures the savings of employed workers against the employment hazard but itcannot insure the savings of the unemployed against the unemployment hazard. Anadvance notice of dismissal can provide additional income insurance. It has twoimplications. It spreads employment income over a longer time horizon, bylengthening the job tenure, and so endogenizes the gap between employment andunemployment income; and secondly, it induces search on the job, and so itintroduces a positive probability that the worker will move from the current job toa more productive one without the income loss associated with unemployment.Both these implications provide additional insurance against income risk due tojob loss.Equilibrium search models with non-linear utility are notoriously difficult to

solve analytically. The small number that have appeared in the literature have beensolved numerically Costain, 1995; Valdivia, 1995; Andolfatto and Gomme,

.1996 . Although I will report some numerical results, one of the purposes of thispaper is to show how non-linear utility can be introduced into search models intractable ways.6I 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 whymoral hazard will prevent full insurance from developing. I then demonstrate, inSection 5, how severance payments can be a perfect substitute for insuranceagainst the unemployment risk, enabling the worker to attain the same consump-

.tion profile whilst employed though not necessarily the same level as with fullinsurance. In Section 6 I show that dismissal delays can provide imperfectinsurance against the unemployment risk, i.e. the uncertainty over the duration ofunemployment. Finally, Sections 7 and 8 work out the implications of the modelfor equilibrium job creation and job destruction. Some remarks on policy implica-tions 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.


2. Types of employment protection

Employment protection encompasses any set of regulations, either legislated orwritten in labor contracts, that limit the employers ability to dismiss the workerwithout delay or cost. The OECD has collected detailed information on five kindsof employment protection. The emphasis in all cases is legislated employmentprotection, because of the difficulty of obtaining information on privately negoti-ated contracts. Their rankings, however, are closely related to the subjectiverankings of the difficulty of dismissal that have been compiled from survey data

.by Di Tella and MacCulloch 1999 . The five kinds of employment protectionlisted by the OECD are:

1. Administrative procedures. This includes requirements such as writing to theemployee concerned or to an organization, for example a trade union, givingreasons for the dismissal, the length of time that the employer has to wait fora response, etc.

2. Notice of termination. The length of notice varies by tenure and includes aperiod of delay, during which the notice is issued but does not becomeeffective.

3. Severance payment, which again varies by length of service.4. Difficulty of dismissal. This category includes mainly the possibility of achallenge by the employee for Aunfair dismissalB and the leniency withwhich the law and courts in different countries deal with such appeals.

5. Additional measures for collective dismissals. Some countries impose morecosts and inconveniences if the dismissals exceed a prescribed number,usually about 10 workers in the same production unit.

My main interest is in types 2 and 3, which are a transfer from the employer tothe employee. One way of looking at the advance notice of termination is as aninformation transfer from the employer to the worker, which has some economicvalue. A severance payment is a direct transfer of money from the employer to theworker upon termination of the contract. Perhaps surprisingly, the implications ofthese two types of firing cost have not been studied as extensively as the other

.types, although there are exceptions; for example, Lazear 1990 on severance .payments and Boeri 1999 on notification.

Types 1, 4 and 5 appear to be mainly ways of making it difficult for theemployer to dismiss a worker without any apparent immediate financial gain to theemployee. Employers may be discouraged from dismissing employees for fear thatthey may be engaged in lengthy and expensive negotiations, or that they may bechallenged in the courts. This type of Afiring costB has been studied extensively inthe literature and it is the one that is mainly held responsible for reducing both jobcreation and job destruction. It is relevant to my argument only to the extent that itacts to delay a dismissal, or induce the employer to AbribeB employees to avoid


lengthy negotiations, and so act as a form of transfer or advanced notice oftermination.Table 1 summarizes the OECDs new data on the minimum length of notice

required by law before dismissal including the number of days required before.notice becomes effective , the minimum severance payment and the OECDs

administrative and overall index of strictness of employment protection legislation .which range from 0 for the least restrictive to 6 . For notice of termination,

Table 1Employment protection legislation, late 1990s

.Country Notice Severance Administrative Overall strictness Rank 121 . . . .months months pay index 06 index 06

EU .Austria 1.5 2.0 3.0 2.3 12 16 .Belgium 2.9 0.0 1.6 2.5 13 17 .Denmark 3.0 0.0 1.7 1.5 08 05 .Finland 2.4 0.0 2.5 2.1 09 10 .France 2.4 0.4 2.7 2.8 17 14 .Germany 1.6 0.0 3.4 2.6 16 15 .Greece 1.5 1.0 2.6 3.5 20 .Ireland 0.6 0.2 2.0 1.1 05 12 .Italy 1.1 3.5 3.0 3.4 19 20 .Netherlands 2.0 0.0 3.9 2.2 10 09 .Portugal 2.7 4.0 3.9 3.7 21 18 .Spain 1.0 2.6 2.7 3.1 18 19 .Sweden 3.5 0.0 3.6 2.6 14 13 .United Kingdom 1.0 0.5 1.0 0.9 02 07

EU average 1.9 1.0 2.7 2.5

Others .Australia 0.8 1.0 1.3 1.2 06 04 .Canada 0.5 0.2 1.4 1.1 04 03 .Japan 1.1 1.5 2.9 2.3 11 08 .New Zealand 1.2 1.5 1.6 0.9 03 02 .Norway 1.1 0.0 3.0 2.6 15 11 .Switzerland 2.0 0.0 1.5 1.5 07 06 .United States 0.0 0.0 0.7 0.7 01 01

.Source, OECD 1999b . Notice period is the required length of advance notice of dismissal plus thetime 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 inbrackets 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 updatedrank for the 1980s is virtually identical to the one for the 1990s.


Fig. 1. Employment protection in the OECD, late 1990s.

severance payments and the administrative index I report only data for regularemployment of 4 years tenure. Only restrictions in legislation are reported; privatecontracts often have their own clauses about severance payment and notice oftermination but data are difficult to get.7The table shows a lot of variation in the strictness of employment protection

legislation, which according to the OECD has shown a lot of persistence betweenthe late 1980s and the late 1990s. In terms of overall strictness, the six countrieswith the least restrictive legislation are the six English speaking countries in thesample, headed by the United States and followed by the United Kingdom. Thefour countries with the strictest protection are the four southern European coun-tries, 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 therequirement of notice, with some exceptions. For example Spain, one of the mostrestrictive countries overall, requires only 1 month of notice after 4 years of jobtenure, but imposes very high severance payments. By contrast, Sweden requiresmuch 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.


countries further away from the origin are the ones with more strict employmentprotection. There is close correlation between the severance payment and noticerequirement on the one hand and the administrative cost of dismissal on the other.

3. Preliminaries: market structure

I study the implications of employment protection in the following simplified .environment. A firm owns a productive opportunity a job which yields constant

w .output p per period when matched to a worker. The job costs Rg 0, p perperiod to run, referred to as the variable cost of the job. At some rate l a negativeshock arrives that reduces the output of the job to zero. When the shock arrives,the firm either closes down the job and dismisses the worker, or gives the workernotice that the job will terminate and she will be dismissed at some future date.We formalize this idea by assuming, in the continuous time environment adoptedin this paper, that notice takes the form of a dismissal probability sd t for a shorttime interval d t. Thus, dismissal is a Poisson event that arrives at rate sG0. In the

steady state, the expected duration of the notice of dismissal is 1rs Garibaldi,.1998 . A high s indicates less employment protection and more employment

Aflexibility,B in the sense that the firm can more quickly realize the desired actionof destroying the job. Given the continuous time environment, we can assumewithout loss of generality that a notice is always given and that the only restrictionon s is that it should be non-negative. ss` is a feasible choice that indicates

.immediate dismissal without notice maximum flexibility . At the other extreme,ss0 is also feasible and indicates the absence of dismissal. Jobs in the latter caseterminate only when the worker quits.Giving notice of dismissal instead of dismissing the worker immediately

involves two types of costs to the firm and worker. First, an unproductive job iskept active instead of shutting it down, and the variable costs R have to be paid.Second, when the worker stays employed, she foregoes her unemployment in-come. Unemployment income is a pure subsidy, so it is a net loss to the pair forthe duration of the notice period. From the purely financial point of view, thematched pair would be better off if the unproductive job were given up and theworker claimed her unemployment subsidy. In contrast, a severance payment is apure transfer made by the firm to the worker when the job terminates, so it doesnot reduce the net surplus created by the job. The transfer, which is denoted by s ,is not made when the worker quits either before or after notice is given, but thestructure of the model is such that there will be no quits before notice is issued.8The fact that the notice period reduces the private surplus from the match makes it

8 The severance payment could also be made available if the worker quits during a notice periodwithout change in the results.


more of a puzzle that it is wanted by workers. We show below that if it is wanted,it is because its insurance properties are better than those of the severancepayment.Workers have infinite horizons and are homogeneous. There are frictions in the

market that stop the instantaneous matching of unemployed workers and vacantfirms. The frictions are summarized in an aggregate matching function that isintroduced later in the analysis. Workers never quit into unemployment or out ofthe labor force. They are either fired into unemployment, at the end of the noticeperiod, or they quit to take another job. We assume that jobs arrive to employedand unemployed job seekers at the same constant rate aG0. Unemployed workersearn income b per period, assumed to be an exogenous subsidy. Employedworkers earn a wage rate w, which is a choice variable.The choices that have to be made are with respect to job creation, job

destruction, wages, job search and severance payment. In addition, workers choosetheir consumption levels given their incomes. We now describe who makes thesechoices and how.Workers choose their consumption profile conditional on their income. I

consider consumption choices when the employment and unemployment risks canbe insured, and show that when the rate of time preference is equal to the rate of

.interest the consumption profile is flat and independent of employment status.This is not a feasible equilibrium, because the incentives to search for a job are notpresent, so I then consider equilibrium when the employment and unemploymentrisks cannot be insured. In order to keep the framework analytically tractable Istudy the extreme of no borrowing or saving, i.e. when consumption is equal tocurrent income.The choice of wage profile becomes key in this case. Employment in the model

is the outcome of a two-sided match that creates some local monopoly rents. Thecommonly used wage equation in this environment is a rent-sharing one that is

usually derived from the solution to a static Nash bargaining problem Pissarides,.2000 . This is one possible wage model for this paper but given the differences in

risk attitudes between firms and workers, a more intuitive wage equation is the one . underpinning the Acompetitive search equilibriumB model of Moen 1997 used

.also by Acemoglu and Shimer 1999 to study optimal unemployment insurance in. .a two-period model . In this framework the firm posts a wage rate or a wage rule

and adheres to it throughout the duration of the job. Workers have informationabout posted wages but because of frictions they do not expect to be offered a jobwith probability 1 if they apply. They can join a pool of applicants and on thebasis of that pool, they are offered the job with some probability less than 1.Workers act competitively, in that they join the pool that maximizes their utility.In equilibrium the wagepool combinations of all firms give the same utility to allworkers, otherwise job applicants will switch pool.

.Moen 1997 shows that in decentralized search equilibrium, the competitivesearch equilibrium assumptions give rise to the unique wage equation that


.internalizes the search externalities Hosios, 1990; Pissarides, 2000, chapter 8 .Namely, the wage rate shares the surplus from the job according to the elasticity ofthe constant-returns matching function with respect to unemployment. The samerule is shown to hold here in the risk-neutral case, but the sharing rule generalizesunder risk aversion. The advantage of the competitive search assumptions, how-ever, are mainly in the choice of the notice of termination, s. I show that if thefirm posts a wage rule, a severance payment and a notice period conditional on thearrival of a bad shock, the severance and notice period that maximize the firmsprofit 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. Iassume that search intensity is fixed and do not make explicit the cost of search. Iassume instead that search takes place if the rewards from finding a new job arestrictly 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`y dqa.tyt .U t s e u c t qaW t dt , 1 . . . . . .H

twhere 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 isaccepted. The latter satisfies

`y dql. zyt .W t s e u c z qlW z d z , 2 . . . . . .H n

t

under the assumption that the worker changes from a productive to an unproduc-tive job at the rate l. The expected lifetime utility from the unproductive jobsatisfies

`y dqaqs. tyz .W z s e u c t qaW t qsU t d t , 3 . . . . . . .Hn

zgiven that this state terminates for two reasons, when the worker quits to take aproductive job and when she is dismissed into unemployment.


The worker maximizes utility in each state by choosing the optimal consump-tion sequence subject to the budget constraints. We say that there is a full set ofinsurance markets when the worker can buy annuities in each state that insure heragainst the risk of income fluctuations, due to changes in wages or employmentstatus. The result is a consumption profile that depends on permanent income, theaverage of income in employment and unemployment. Making the additionalassumption that the rate of interest is equal to the rate of time preference, rsd ,

.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,u c .

WsW sUs . 4 .n rLifetime utility is identical in employment and unemployment. Thus, completeinsurance markets create conventional moral hazard: workers do not have anincentive to search for a job and the market breaks down.Notwithstanding this problem, it is helpful for the later analysis to investigate if

there is any role for employment protection in this environment. In order to closethe model, suppose that wages are determined by zero-profit conditions on firms.With discount rate r and termination rate l for the productive phase of the job, the

. .present discounted value of profit in the productive phase is pyRyw r rql .The unproductive phase is entered at rate l and terminates at rate aqs. It coststhe firm Rqw and if it terminates with dismissal, there is a severance payment ofs . Therefore, the present discounted value of profit is

pywyR l RqwqssJs y . 5 .rql rql rqaqs

.The second term in the right-hand side of Eq. 5 is the loss suffered because thejob is kept active during an unproductive period with the exception of the

.severance payment, which has to be paid anyway . It is maximized when ss0,when the job is destroyed only when the worker quits and minimized when ss`,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 equationrqaqs pylss .

ws yR . 6 .rqaqsqlWages 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

rqa l sby rqa R . .cs pyR q . 7 . .rqaql rqaql rqaqs . .


It follows from this analysis that neither severance payments nor notice oftermination have a role to play. Severance payments are irrelevant, as they can beundone by private insurance markets. But the notice of termination makes theequilibrium worse because it reduces income and consumption. Consumption

.without a delay in dismissal ss` isrqa pyR qlb . .

cs . 8 .rqaqlWith a complete set of insurance markets, the individual can arrange the incomefrom work in such a way as to maximize consumption.

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 freedomto 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 tomaintain her consumption level during unemployment. In the absence of insurancemarkets, and because of the risk of the early arrival of a negative shock, theworker will want to save a lot at first, but less as the job tenure rises and assetsaccumulate. So the optimal consumption path during employment rises. Theseverance payment acts as insurance against the employment risk: the worker paysa premium in the form of a wage reduction, and the firm guarantees a payment ontermination that is independent of the duration of the job. The optimal payment ischosen so that consumption during unemployment is maintained at a level that isoptimal 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, supposethe worker does not have access to a capital market at all. The firm, however, hasfull access. The worker chooses an optimal consumption profile and severancepayment and the firm finances this profile, by making wage payments that exactlymatch, in each period, the chosen consumption.

.Let A t be the net asset position that the worker implicitly has with the firmw .during the productive phase of the job and A t the asset position at the start ofn

the unproductive phase of the job. The firm AreceivesB from the worker, during .the productive phase income flow pyR, makes a payment c t , and can invest

.the net position A t at the safe interest rate r. Hence, the evolution of thewworkers net asset position with the firm under zero profits is

A t srA qpyRyc t ql A t yA t , 9 . . . . . .w w n wgiven that the state changes at rate l.


.Maximization of Eq. 2 with respect to the consumption sequence and the . . . .assets A t and A t , subject to Eq. 9 , gives for rsd a flat wage profilew n

during the productive phase of the job andEW t .nXu c s , 10 . .w EA t .n

.where now A t is the workers initial asset position with the firm when thenproductive 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-profitconstraint the workers net asset position evolves according to

A t srA t yRyc t qaA t qs A t ys t 11 . . . . . . . .n n n n .Maximization of the utility function in Eq. 3 subject to the budget constraint in

.Eq. 11 gives again a constant consumption profile andEW t EU t . .n Xsu c s . 12 . .nEA t Es t . .n

. .Combining the result in Eq. 12 with the result in Eq. 10 , we find that whenthere are optimal severance payments, the worker can maintain a flat consumptionprofile throughout her tenure on the job: the firm pays the worker a fixed wageand a lump sum when she is dismissed, and the worker does not need access toeither an insurance market or to a capital market. The firm can offer a perfectsubstitute for each.

6. Advance notice of dismissal

The role of an advance notice period is more difficult to derive. With optimalseverance payments, the worker uses her firm as a banker. Savings outside thefirm do not have a role to play, and can be set identically equal to zero withouteffect on the solution. During unemployment, however, and when the paymentsreceived from the exogenous unemployment insurance are insufficient, the workerwill want to save the severance payment in a bank and run it down graduallyduring search. Because of the chance of finding a job quickly, consumption at firstwill be maintained at a high level but will be run down during unsuccessful search.The delay in dismissal gives two kinds of insurance protection to the worker: itintroduces a chance that job change might take place without a drop in income,


following on-the-job search; and it extends the length of time that the worker canuse 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 asinsurer. I derive the implications of no insurance here when in addition theunemployed worker has no access to a capital market; i.e., when consumption isidentically equal to income. This restriction was of no consequence to thepreceding section; it is here, but facilitates the exposition and can help me makethe 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 . " .4unemployment, it is u b . The choice variables are the wage profile w t and the

notice of termination s, given the constraint that jobs require compensation R perperiod and given the arrival rates of new productive opportunities, a, and negativeshocks, l. Our assumption that the unemployed cannot save makes severancepayments 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 thatworkers are risk averse and firms risk neutral. The Pareto allocations are chosenby maximizing the employed workers lifetime utility subject to a zero profitconstraint on firms.The present discounted value of profits for a job beginning at time 0 when

wages are not constant are`

rql. tJs e pyw t yRqlJ t d t 13 . . . .H n0

.where J t is the present discounted value of profits during the unproductivenphase of the job, beginning in period t:

`y rqaqs.tyt .J t s e w t qR dt . 14 . . . .Hn

t

Workers who accept productive opportunities are constrained by the requirementthat the net PDV of a job has to be nonnegative; i.e. the maximization isconstrained by

JG0. 15 . . .Utility functions are as in Eqs. 1 3 for dsr and with consumption during

. . .employment constrained by c t sw t and during unemployment by c t sb. A

9 It is hoped to work out the full solution with a capital market in future work. Preliminary findingsindicate that the main results discussed here are valid.


worker who receives a productive opportunity in this environment is confrontedwith the following maximization problem:

max W s.t. JG0. 16 ." .4w t , s

Let m be a co-state variable associated with the constraint. Not surprisingly, theEuler conditions with respect to the wage path confirm the results of the precedingsection. The wage path chosen is flat and satisfies

uX w sm. 17 . .This choice is dynamically consistentno individual will ever choose a varyingwage profile, given the concave utility function.

.Integration of Eq. 13 for a flat wage structure gives the firms PDV of profit .in Eq. 5 for ss0. If there is delay in dismissal, the profit loss is

RqwJ sy . 18 .n rqaqs

The utility functions satisfyu b qaW .

Us 19 .rqaduring unemployment,

u w qaWqsU .W s 20 .n rqaqs

when the worker is employed in an unproductive job, andu w qlW . nWs 21 .rql

. .when she is in a productive job. The bar on the W in Eqs. 19 and 20 indicatesthat 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 afterthe arrival of the negative shock. When a worker first enters a job, she receives acontract that specifies a stationary wage profile for an average of 1rlq1rsperiods, 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 signof EW rEsqmEJ rEs, which at the stationary w satisfiesn n

EW EJ rqa Uyu w yaWqm wqR . . .n nqm s . 22 .2Es Es rqaqs .


. . .Eqs. 1 and 17 imply that we can write Eq. 22 asEW EJ u b yu w quX w wqR . . . .n nqm s . 23 .2Es Es rqaqs .

.The constraint 15 will hold as equality at the maximization point, giving theoptimal wage level as

rqaqsws pyR . 24 .rqlqaqs

Note that at ss0, when the job is never terminated,rqa

w s pyR 25 .0 rqlqaand at ss`, when the job is terminated when it becomes unproductive,

w spyR . 26 .` .Now, ss0 cannot be an equilibrium because in symmetric equilibrium utility

functions becomeu w .

WsW s 27 .n rand the equilibrium is trivial because no one has an incentive to search for a

.productive job. If Eq. 23 is positive at all sG0, we therefore arbitrarily fix s atsome low positive value. We will, however, be interested in parameter ranges thatimply that if s is finite, it is an interior maximum. For a nonzero s, utilityfunctions in symmetric equilibrium satisfy

s u w yu b . .WyW s 28 .n rqaql rqaqs . .

andu w yu b . .

W yUs , 29 .n rqaqsso 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. 2shows 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 betweenincome in work and income out of work is reduced. Also, for given duration ofsearch, the time that the individual spends in unemployment, when income andconsumption are lower, is reduced. We will see shortly that the optimal noticeperiod is one that achieves an optimal relation between the wage rate andunemployment benefit, given that the longer the notice period is, the lower thewage rate becomes.


Fig. 2. Income path with and without a notice period.

.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 yu w quX w wqR , 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 itsinsurance properties. Table 2 reports some numerical results for the optimality of a

Table 2Values of the replacement ratio below which it is optimal to give noticeg Rr p rmax0 0.0 0.000.5 0.0 0.250.5 0.3 0.081 0.0 0.371 0.3 0.241.5 0.0 0.441.5 0.3 0.342 0.0 0.502 0.3 0.415 0.0 0.675 0.3 0.62

g is the constant coefficient of relative risk aversion, Rr p is the cost of running the job per units ofoutput and r is the ratio of unemployment compensation to the wage rate.


finite s. I show the range of the replacement ratio, defined by brw'r, for which .the sign of f s;. is negative at ss`. The exercise is conducted for a constant-

relativerisk-aversion utility functionw1yg

us . 31 .1yg .Since for this utility function, f s;. is monotonically increasing in r, I find the

.value of r that implies f `, r s0. Any value of r below this critical valueimplies that the optimal s is finite. I denote the critical value of the replacementratio by r . This is given bymax

.1r 1yggyRrpr s . 32 .max /1yRrp

The table shows the range of r for two values of the variable cost of keepingthe job active, 0 and 0.3. In the latter case the cost of giving notice is higher soworkers need a lower replacement ratio to induce them to stay on the job after itbecomes unproductive. The first line of the table confirms that if there is no riskaversion, the job is always destroyed when it becomes unproductive. Smalldegrees of risk aversion require only modest unemployment income to inducefiring but once the degree of risk aversion becomes large, even generous unem-ployment 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 needsinsurance; i.e. if she is risk averse and unemployment insurance is insufficient.10Other 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 forgiven arrival rate of jobs. The job destruction rules can be derived from theanalysis so far. A fraction of unproductive jobs is destroyed each period. Ifproductive employment is e and unproductive n, in a steady state the equalitylessn holds. Job destruction is given by sn and the job destruction rate by

. .snr nqe , which, given that nslers, is equal to lsr lqs . Thus, faster

10 .Boeri et al. 2000 find some evidence of a trade-off between the generosity of unemploymentinsurance and the strictness of employment protection a sub-sample of OECD countries.


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 w tiand a dismissal rate s , conditional on the arrival of a negative shock, an event thatitakes place at rate l. Given this posting a number of workers apply to the firm forthe job. Let the ratio of the pool of vacant jobs that post this contract to the pool ofapplicants be denoted by u , referred to as the tightness of market i. Some of theseiapplicants may be suitable and some not. I assume that the rate of success for eachjob vacancy i is given by a constant-returns matching function, which defines a

. X .rate of arrival of workers to vacant jobs q u , with q u F0 and elasticityi i .yhg 0, 1 , assumed for convenience to be constant in the neighborhood of

equilibrium.11A 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 samewage 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 q u , an implication of the matching technology. Thei i

expected returns of this worker from joining pool i generally depend on whetherthe worker is unemployed or employed on notice of dismissal. I will work out thesolution when the firm posts a wage to attract unemployed job applicants. Thesolution is not qualitatively different if it aimed its offer at employed jobapplicants, a point discussed briefly in footnote 12.The expected returns of the unemployed applicant are given by U , calculatedi

. .from Eqs. 1 3 when the consumption flow during employment is equal to the .posted wage w t , the dismissal rate is sss , and the arrival rate of jobs isi i

.asu q u . Let U be the returns from joining the pool with the most attractivei iposted contract. Then the constraint facing firm i is

UGU. 33 .iThe 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 V be the expected profits from joining pool i with a vacant job. Iiassume that creating the vacant job is costless but maintaining it open and

11 .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.

Georgiana Modoran

Georgiana Modoran

Georgiana Modoran


participating in the matching game costs k per period. The value of the vacancytherefore satisfies

rVsykqq u J yV , 34 . . .i i i iwith J denoting the expected profit from a filled job that belongs to pool i. Theifirm posts the wage contract that maximizes the value V .iNow, 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 willchoose to post a flat wage profile. I simplify the derivation of the searchequilibrium by imposing the flat profile from the outset and so define themaximization program as

ykqq u J .i imax Vs , 35 .i rqq uw , s ,u .i i i ipyw yR l Rqwi iJ s y 36 .i rql rql rqaqsi

subject tou b qu q u W . .i i iUs GU, 37 .i rqu q u .i iu w l u w qaWqsU . .i iWs q . 38 .i rql rql rqaqs

The transition rates to jobs after the termination of job i and the expected returnsfrom such transitions are unspecified for the moment.Maximization with respect to w and u gives the rulesi i

q u 1 u q u uX w . . .i i i iy qm s0, 39 .rqq u rql rqu q u rql . .i i iqX u J yV q u 1yh . . . .i i i iy qm WyU s0, 40 . .i irqq u rqu q u . .i i i

where m is a Lagrangian multiplier and h is the elasticity of the vacancys . . 12transition rate. From Eqs. 39 and 40 I derive the sharing rule

hXWyUs u w J yV . 41 . . .i i i i i1yh

12 .Eq. 41 is the only one that would change if the firm aimed its offer to employed job applicants,n . .because their gain from the offer would be WyW and not WyU . But Eqs. 28 and 29 show thati i i i

the two gains are proportional to each other, so nothing of substance changes if we use one rather thanthe other.


For a linear utility function, this rule internalizes the search externalities. Maxi-mization with respect to s gives the following condition for an interior solutioni

q u Rqw .i i2rqq u . rql rqaqs . .i

u q u rqa UyaWyu w . . .i i iqm s0. 42 .2rqu q u . rql rqaqs . .i i .If the expression is positive everywhere, the optimal s is ` no notice is given ,i

.and if it is negative everywhere, s takes its arbitrary minimum value consistenti . .with search on the job. Making use of Eqs. 19 and 39 I derive the same

condition as in the preceding section for the optimality of an interior s , with theiconditions for the bounds following easily:

u b yu w quX w w qR s0 43 . . . . .i i i . .Conditions 41 and 43 are solved for the firms wage rate and optimal

dismissal policy, given the tightness of its market u . Tightness is derived from thei .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 workerfrom search. I close the model by assuming that the aggregate equilibrium issymmetric, i.e. by writing wsw , WsW and UsU . This, however, tells usi i ithat tightness is the same in all sub-markets, not what it is. In order to derive thevalue taken by tightness I impose the usual zero-profit condition on new jobcreation; i.e. I assume that firms will create vacant jobs up to the point where allrents from job creation are exhausted. This gives Vs0 for all i. Notingi

. .conditions 34 and 36 and the symmetric equilibrium we derive the job creationcondition

rqsqlqu q u rql k . .py wqR s . 44 . .rqsqu q u q u . .

.The right-hand side of Eq. 44 is the expected cost of recruiting a worker and the .left hand-side for ss` is the net revenue from this worker, py wqR . Thus,

.Eq. 44 is a generalized demand for labor curve, which equates net revenue tocosts 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 Vs0 to substitute the value functions out of Eq.

.41 . The result is the new sharing equationu w yu b hk rqu q u ql rqu q u qs . . . . . .

s .Xu w 1yh q u rqsqu q u ql . . . .45 .


. . .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 theequilibrium solution for s and u .

8. The role of employment protectionA 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 expectedoutput. The implied mean duration of search is 2.7 months and mean duration ofnotice 1.7 months. In the case where no notice is given, the mean duration ofunemployment 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 andout of each stock. The results of the table show that the notice period does notaffect the productive employment rate. If notice is not given, those on notice,about 2% of the labor force, become unemployed, wages rise with virtually noother change. Since workers are risk averse, they are made worse off by thischange. Unemployment and its duration are much higher in the absence of notice.Equilibrium satisfies some strong properties with respect to the policy parame-

.ters. Making use of the insurance condition 43 to substitute wages out of Eq. . . .45 , and then combine Eqs. 44 and 45 , we obtain

h kps rqu q u ql qrql . 46 . . . /1yh q u .

The tightness of the market is determined independently of the parameters of theunemployment insurance system or any features of employment protection. Job

Table 3Numerical illustration of the search equilibrium

Equilibrium solutionWith notice Without notice

w 0.920 0.939brw 0.500 0.490 . .krq r prl 0.050 0.0511ru q 0.225 0.2211r s 0.142 0.000e 0.947 0.948n 0.020 0.000u 0.033 0.052

1yg . yhps1, ks0.045, Rs0, ls0.25, rs0.05, usw r 1yg , gs2, qsu , hs0.5, bs0.46. . .The fraction krq r prl is the mean recruitment cost over the mean output over the life of the job.

1ru q is the mean duration of search and 1r s the mean duration of notice. e is the steady-state stockof productive employment, n of unproductive employment and u is the unemployment rate.


. .creation is given by u q u 1ye , 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 jobcreation.In order to illustrate further this property, I consider the properties of equilib-

.rium 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. Thiscurve is shown in Fig. 3 as a downward-sloping Ajob creation curve.B Now, anincrease 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 , shorteradvance 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 higherwage costs. This illustrates an important point: employment protection and unem-ployment insurance are closely linked, and giving more of one and less of theother 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 wagecurve up, but because the notification requirement is held fixed, equilibriummoves up the job creation curve, leading to less job creation.

Fig. 3. Effects of higher unemployment insurance when the notice period is optimal.

Georgiana Modoran


Fig. 4. Effects of higher unemployment insurance when the notice period is exogenous.

Finally, consider an exogenous reduction in employment protection in the .equilibrium described in Fig. 4 Fig. 5 . For example, suppose the government

fixes the advance notice requirement at a level that is above the optimal level .implied by Eq. 43 and subsequently reduces it. In Fig. 5, the job creation curve

shifts to the right, and the wage curve shifts up. The effects are the conventionalones of relaxing employment protection: job creation increases because the costsof opening a job are less and wages rise because less time is now spent in the

Fig. 5. Effects of shorter notice period when it is exogenous.


unproductive phase of a job. Although the overall effects on job creation are notclear 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 destruc-tion, as in conventional models.

9. Conclusions

I have argued that the models used to evaluate employment protection legisla-tion are not usually models that justify the existence of the legislation and so theyare not appropriate for a full evaluation. I demonstrated that employment protec-tion can provide insurance against income risk, when moral hazard or otherproblems prevent unemployment insurance from providing sufficient cover. Sever-ance payments can provide perfect insurance against the uncertainty of the

.duration of a job the unemployment risk . Dismissal delays reduce the meanlength of time that the worker spends unemployed and make it possible to choosethe gap between income in work and income out of work. I conclude bysuggesting 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 privatecontracts. This is not a question that I investigated so I cannot give a completeanswer. But under the employment protection rules that I derived, the worker paysfor the protection in the form of a lower wage rate for the duration of theproductive phase of the job and is compensated with higher income when the jobis no longer productive and dismissal becomes imminent. One can easily arguethat the firm will have incentives to default on its obligations and terminate thecontract without compensating the worker. Of course, with written employmentcontracts, a defaulting firm can be taken to court. But the transfers involved areusually small and if the courts are expensive this is not a realistic option.Legislation can provide a cheaper alternative of enforcing rules that would beoptimal 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 packageof measures, and when shocks take place the employment protection is changedalong with wages and other features of the contract. Without this flexibility in theprotection legislation, the measures may alter the relative bargaining powers ofestablished workers and employers, and alter wages and job creation. Employmentprotection may then have the kind of implications for the functioning of labormarkets that have been discussed in the literature: established workers gainingpower 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,


there would be no need for employment protection. The question why it is easierto legislate employment protection than unemployment insurance, at least in somecountries, 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 ofintroducing and running an unemployment insurance scheme will have to be takeninto account if the relative merits of the two ways of providing insurance are to becompared. A gain from unemployment insurance, however, that is not usuallymentioned in the policy debate but emerges out of our analysis, is that in countrieswith poor unemployment insurance provision and strict employment protection

.measures the southern European states being a good example , making unemploy-ment insurance more generous can have an additional efficiency gain: the disman-tling of expensive firing procedures, and the faster destruction of unproductivejobs.

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 marketcharacterized by the unique interest rate r and that can pool resources to insureagainst the risk of income fluctuation. Let the worker deposit her assets with thisinsurance company and let the assets of the unemployed worker at some time t be

.A t . The insurance company offers a contract which pays a rate of return buduring unemployment and a lump sum A when the worker finds a job but getsw0to keep the accumulated deposit A . The rate of return b is calculated fromu tactuarial 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 yA . Itw0 upays bd t for the duration of the contract, so actuarial fairness requires

bA srA ya A yA . 47 . .u u w0 uThe unemployed workers budget constraint is therefore given by

A sbA qbycs rqa A yaA qbyc, 48 . .u u u w0 .with initial condition A 0 sA qs , given that the unemployed worker re-u u0

ceives severance payment s .The budget constraint of employed workers is calculated in similar fashion. The

worker on notice deposits assets A with the insurance company and gets A ifn u0she becomes unemployed or AX if she becomes directly employed, both of whichw0are choice variables. She also gets severance payment s if she becomes unem-ployed. Her budget constraint satisfies

XA s rqaqs A yaA ysA qwyc, 49 . .n n w0 u0 .with initial condition A 0 sA . The initial condition is chosen by the workern n0

employed in a productive job, who deposits assets A and gets back from thew


insurance company assets A when she is given notice of termination. Then0budget constraint of those employed in productive jobs therefore satisfies

A s rql A ylA qwyc, 50 . .w w n0 .with initial condition A 0 sA if the worker came to the job via unemploy-w w0

. Xment or A 0 sA if she came to it from another job after giving notice ofw w0termination.Maximization of lifetime utility with respect to consumption and asset holdings,

given some initial asset position, gives the optimal consumption path. In fact, notall asset positions are needed to achieve maximum utility. The way the insurancecontract works is that the worker deposits an initial asset with the insurancecompany and chooses the terminal asset payout so as to achieve the desiredconsumption sequence between the two dates. Since the worker rotates betweenemployment and unemployment, both initial and terminal asset positions arechoice variables. There is an infinite number of initial and terminal asset positionsthat can support the same consumption path in-between. We can therefore setarbitrarily initial assets at some level, e.g. 0, and derive the optimal asset positionsfrom there onward. What is of interest to us here, however, is not the assetpositions 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 rsd , is stationary. We will make the

assumption rsd and therefore write simply c for the maximizing constantconsumption level. For a constant wage rate w an innocuous assumption in this

.context , the optimal consumption level can be shown to berqa rqsqaql wqls bq rqa s . . . .

cs 51 .rqaql rqaqs . .

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