Modelling Labour Demand Dynamics beyond the Frictionless Environment

In this study we develop a simple econometric model for labour demand dynamics by explicitly considering deviations from the standard frictionless economic environment. In particular, we explore the potential effect on labour demand of capital market imperfections, labour market institutional rigidities in the form of union power, and the impact of uncertainty. In addition, in the presence of uncertainty, adjustment costs and irreversibility emerge as an important factor that introduces an option value of waiting. According to our results, leverage exerts a direct negative impact on employment dynamics indicating that capital market imperfections are indeed present. Moreover, leverage is found to also affect the adjustment process of employment. Finally, we document asymmetric effects of frictions on labour demand across different size groups that imply a higher vulnerability of small and medium sectors with respect to debt levels. Uncertainty exerts a significantly negative impact on labour demand, which is compatible with presence of partial irreversibility of employment decisions. Finally, unions over and above their effect via higher wages are positively related to employment, a finding that is indicative of their pursue for job security. Copyright 2006 The Authors; Journal compilation 2006 CEIS, Fondazione Giacomo Brodolini and Blackwell Publishing Ltd..