Employment fluctuations in a dual labor market

In light of the huge cross-country differences in job losses during the recent crisis, we study how labor market duality - meaning the coexistence of "temporary" contracts with low firing costs and "permanent" contracts with high firing costs - affects labor market volatility. In a model of job creation and destruction based on Mortensen and Pissarides (1994), we show that a labor market with these two contract types is more volatile than an otherwise-identical economy with a single contract type. Calibrating our model to Spain, we find that unemployment fluctuates 21% more under duality than it would in a unified economy with the same average firing cost, and 33% more than it would in a unified economy with the same average unemployment rate. In our setup, employment grows gradually in booms, due to matching frictions, whereas the onset of a recession causes a burst of firing of "fragile" low-productivity jobs. Unlike permanent jobs, some newly-created temporary jobs are already near the firing margin, which makes temporary jobs more likely to be fragile and means they play a disproportionate role in employment fluctuations. Unifying the labor market makes all jobs behave more like the permanent component of the dual economy, and therefore decreases volatility. Unfortunately, it also raises unemployment; to avoid this, unification must be accompanied by a decrease in the average level of firing costs. Finally, we confirm that factors like unemployment benefits and wage rigidity also have a large, interacting effect on labor market volatility; in particular, higher unemployment benefits increase the impact of duality on volatility.