Employment Protection Legislation and Adverse Selection at the Labor Market Entry

This paper investigates how the labor market institutions that characterize most of the Euro- pean countries a®ect the integration process of younger workers on the labor market. We argue that young workers have private information about their abilities when entering the labor mar- ket. However, this information asymmetry does not prevail as the production process reveals the worker's type. Adverse selection distorts hiring practices at the labor market entry. We develop a dynamic principal-agent model and ¯rst derive the optimal menu of labor contracts employers can use as a self-selection mechanism. Firms o®er an increasing wage to high-productive workers while a °atter wage pro¯le to low-productive workers. Our theory suggests that a high level of ¯ring costs as well as the presence of a minimum wage prevent employers from o®ering separating contracts to new entrants and thus contribute to the time-consuming integration process of youth. Finally, we provide numerical exercises to illustrate our theoretical ¯ndings on the optimal wage pro¯le and to assess the consequences for employment opportunities.