The Effects of Firing Costs on Labour Market Dynamics

Using a search and matching model with distinct intensive and extensive labour margin choices and costly firing, we argue that firing costs can account for the observed cross‐country differences in the cyclical behaviour of labour market aggregates. More restrictive employment protection legislation is associated with larger fluctuations in job‐creation relative to job‐destruction flows, larger fluctuations in the intensive relative to extensive margin of labour, and a weaker short‐run Beveridge curve relation measured as the negative contemporaneous correlation between unemployment and vacancies. A calibrated version of our model can explain these empirical observations quantitatively. In the model, firms opt to adjust labour input more strongly along the hiring margin and the intensive margin of labour when firing costs are increased. Hence fluctuations in the job‐creation relative to job‐destruction flows, and fluctuations in the intensive relative to extensive margin of labour rise. Because hiring takes longer than firing, the substitution of the firing margin with the hiring margin leads to a more sluggish response of unemployment to shocks and hence weakens the negative contemporaneous correlation between unemployment and vacancies.