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Optimal severance pay in a matching model

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  • Giulio Fella

Abstract

This paper extends Mortensen and Pissarides (1994) by introducing workers' risk aversion. In doing so, it provides a framework within which to study jointly the optimal supply of job security and the allocational and welfare consequences of government intervention in excess of private arrangements. Firms offer insurance in the form of simple explicit employment contracts featuring productivity-independent wages and severance pay. Contracts can be renegotiated ex post by mutual consent. Laissez-faire contracts are never renegotiated and fully insure workers. Positive severance payments are part of an optimal contract whenever employed workers enjoy positive rents over their unemployed counterparts. The optimal severance payment size is increasing in the expected income loss associated with job mobility. Hence it is positively related to unemployment duration. We present empirical evidence that legislated job security is positively correlated with the optimal severance pay according to the model. Such evidence cannot be explained in terms of reverse causation from high state-mandated job security to high job duration. Legislated firing costs well in excess of privately optimal ones have negligible welfare effects and a small negative impact on unemployment and its duration as wages fall to minimize the distortion.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2004 Meeting Papers with number 794.

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Date of creation: 2004
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Handle: RePEc:red:sed004:794

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Keywords: Contracts; severance pay; matching;

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  1. Topel, Robert, 1990. "Specific capital and unemployment: Measuring the costs and consequences of job loss," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 33(1), pages 181-214, January.
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Cited by:
  1. Saltari, Enrico & Tilli, Riccardo, 2009. "The role and significance of endogenous firing costs in a matching model with endogenous job destruction," Journal of Behavioral and Experimental Economics (formerly The Journal of Socio-Economics), Elsevier, vol. 38(5), pages 799-808, October.
  2. Fabien Postel-Vinay & Hélène Turon, 2010. "On-The-Job Search, Productivity Shocks, And The Individual Earnings Process," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 51(3), pages 599-629, 08.
  3. repec:hal:wpaper:halshs-00590726 is not listed on IDEAS
  4. Federico Cingano & Marco Leonardi & Julián Messina & Giovanni Pica, 2010. "The effects of employment protection legislation and financial market imperfections on investment: evidence from a firm-level panel of EU countries," Economic Policy, CEPR & CES & MSH, vol. 25, pages 117-163, 01.
  5. Dennis Wesselbaum, 2010. "Firing Tax vs. Severance Payment - An Unequal Comparison," Kiel Working Papers 1644, Kiel Institute for the World Economy.
  6. Delacroix, Alain & Wasmer, Etienne, 2009. "Layoff Costs and Efficiency with Asymmetric Information," IZA Discussion Papers 4524, Institute for the Study of Labor (IZA).
  7. Usui, Emiko, 2007. "Severance payments in equilibrium unemployment," Economics Letters, Elsevier, vol. 94(3), pages 342-347, March.
  8. Jean-Baptiste Michau, 2012. "Optimal labor market policy with search frictions and risk-averse workers," Working Papers hal-00757173, HAL.

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