Employment protection

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.

Introduction

The question of “labor market flexibility” 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 world's economies during 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 change—leading to a large increase in unemployment, failure to increase employment amongst “minority” groups and failure to take advantage of the technological revolution: the term “eurosclerosis” 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, “employment protection”, 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 employer–employee 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 OECD's 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

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 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 “implicit contract theory” 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 “real wage rigidity,” and the second the less celebrated “over-employment.” 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 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 “notice of dismissal” 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, 7 Search equilibrium, 8 The role of employment protection 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.