International Finance Discussion Papers

Labor Market Rigidities and Unemployment: The Case of Severance Costs Michael K. Gavin 1986-284  (June 1986)

Abstract:  It is frequently alleged that the persistent, high rates of unemployment in many European countries are due, at least in part, to various labor market rigidities. One of these rigidities is the high cost of firing workers, compared with the cost in the United States, or in Europe in the early 1960s.

This paper assesses the empirical importance of severance costs on labor demand. A partial equilibrium model of the firm's employment decision in the presence of significant severance costs is formulated and solved. The theoretical section of the paper identifies the following determinants of the impact of severance costs on labor demand: (1) the size of the required severance payments, (2) the variability and persistence of shocks to labor demand, (3) the expected rate of growth of labor demand, (4) the rate at which workers voluntarily leave the firm to retire or take other jobs, (5) the wage elasticity of labor demand, and (6) the firm's discount rate.

The analytical framework is then used to evaluate the impact of severance costs on the expected cost of hiring a worker, and hence on labor demand. These costs are evaluated for a plausible base case, and the sensitivity of the conclusions to alternative assumptions is investigated.

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