Employment Protection and Unemployment in an Efficiency Wage Model

Firing costs are often blamed for unemployment. This paper investigates this widespread belief theoretically. The main points are two. First, firing costs are introduced in an efficiency wage model to capture their effects on employment though wages. Second, dismissal conflicts are modeled explicitly and their cost is derived. These two elements are put together and linked. In this way, the model integrates very different views put forward by different economists depending on the model used: the view that firing costs reduce employment, the idea that firing costs are neutral on employment if markets are perfect and complete, and also the possibility that firing costs are chosen voluntarily by firms. Modeling firing costs in a context where worker effort is not perfectly observable implies that a double moral hazard problem could arise. Whenever firms face a redundancy, they tend to use disciplinary dismissals in order to avoid paying firing costs. Similarly, workers will then tend to deny any disciplinary case to get a compensation. My claim in this paper is that the resolution of this problem by a third party will be imperfect given the information problem. This will in turn imply that disciplinary dismissals will not be costless, and therefore firing costs will have a negative effect on aggregate employment. Some policy implications are discussed. In particular, it is found that the solution to the problem does not necessarily imply the elimination of firing costs