The Role of Policy in a Matching Model with Judicial Interference

Economic literature on the labour market has not found univocal results concerning the effects of employment protection on unemployment (Bentolila and Bertola 1990; Bertola 1990; Lazear 1990). The reason is that employment protection produces two effects that work in opposite directions: on one hand, employment protection prevents firing, while, on the other hand, it discourages firms from hiring workers, because their subsequent dismissal is costly. Unemployment increases only if the second effect dominates the first, but it is not possible to establish "a priori" which of the two will prevail. Recently, Ichino, Polo and Rettore (2001) have shown that judges can be biased by labour market conditions, that is they tend to interpret employment protection legislation in favour of workers when labour market conditions get worse for them. This fact has interesting macroeconomic implications, when studying labour market structure and economic policy. The first point has been already considered in Tilli (2002), where he assumed firing costs as a decreasing function of labour market conditions and he determined their effective level endogenously. The main qualitative result obtained from this "judicial interference" is that employment protection legislation which allows the judges a large degree of interpretation, can increase the institutional rigidities of the labour market. In this paper we study the effects of five policy instruments on equilibrium unemployment in a search and matching model with judicial interference. We consider firing costs as an inverse function of labour market conditions so, when labour market conditions worsen for workers, the interpretation activity of judges tends to increase the strictness of employment protection legislation. An interesting feature of the model is that it can potentially produce multiple equilibria, which could reflect different labour market structures in terms of inflows into unemployment and average duration of unemployment. In the case of unique equilibrium, the qualitative analysis shows that some policy instruments could potentially change the direction of the effects on equilibrium unemployment when judicial interference works. The results of a numerical simulation confirm that the effects of some policy instruments may have different impacts on equilibrium unemployment when there is judicial interference. In particular, active labour market policies, such as hiring and wage subsidies, may reduce the strictness of employment protection with positive effects on welfare. Regarding passive policies, judicial interference may limit the increase of the unemployment rate caused by unemployment benefits, but this leads to a lower level of welfare.