The Effect of Labour Turnover Costs on Average Labour Demand When Recessions Are More Persistent than Booms

This paper examines how labour turnover costs affect average labour demand when troughs are more persistent than booms. We show that the effect of firing costs on average labour demand is more expansionary (or less contractionary): the greater is the difference between the persistence of troughs and the persistence of booms, and the more prolonged are the macroeconomic shocks. This analysis may shed some light on the expected effect of a reduction of firing costs when an economy is suffering more prolonged recessions (relative to booms): average labour demand will be lower. 1. Introduction Politicians and journalists often attribute the high unemployment in many European countries to their stringent job security legislation, and particularly to their state-mandated firing costs. However, the theoretical literature on the long-run effects of firing costs on employment has generated mixed results (There is also no agreement in the empirical literature. See OECD [1], Layard et al. [2], Lazear [3], Bertola [4], Hopenhayn and Rogerson [5], Nickell [6], Heckman and Pages [7].). Bentolila and Bertola [8] and Bertola [9] have argued that firing costs tend to raise (rather than reduce) the average level of employment since they discourage firing more than hiring in any given firm. Other contributions show factors that pull in the opposite direction: Bentolila and Saint-Paul [10] indicate that when firms face heterogeneous productivity shocks, a rise in firing costs reduces the number of firms engaged in firing. Hopenhayn and Rogerson [5] consider that the increase in firing costs reduces the entry of firms (in an industry equilibrium with firm entry and exit) and thus labour demand falls. Díaz-Vázquez et al. [11] show that when there is on-the-job learning, an increase in firing costs may reduce average employment over the cycle. This paper and Díaz-Vázquez and Snower [12–14] also show that the wage effects of firing costs may reduce average employment (as shown in the literature, firing costs give power to insiders in the wage negotiation (see Lindbeck and Snower, [15])). Ljungqvist and Sargent [16] argue that the existence of firing costs can help explain the high European unemployment of recent decades. However, this literature has not investigated how the average employment effect of firing costs depends on the asymmetry in the persistence of macroeconomic booms and troughs (in Bentolila and Bertola [8], the shocks are permanent (namely, they are assumed to follow a random walk process), whereas in Bentolila and Saint-Paul [10] they are temporary (namely,