Pareto-improving firing costs? |
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Authors: | Bilgehan Karabay John McLaren |
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Affiliation: | aDepartment of Economics, University of Auckland, Owen G Glenn Building, 12 Grafton Rd., Auckland 1010, New Zealand;bDepartment of Economics, University of Virginia, P.O. Box 400182, Charlottesville, VA 22904-4182, United States |
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Abstract: | We examine self-enforcing contracts between risk-averse workers and risk-neutral firms (the ‘invisible handshake’) in a labor market with search frictions. Employers promise as much wage-smoothing as they can, consistent with incentive conditions that ensure they will not renege during low-profitability times. Equilibrium is inefficient if these incentive constraints bind, with risky wages for workers and a risk premium that employers must pay. Mandatory firing costs can help, by making it easier for employers to promise credibly not to cut wages in low-profitability periods. We show that firing costs are more likely to be Pareto-improving if they are not severance payments. |
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Keywords: | Implicit contracts Invisible handshake Firing costs |
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