Employment protection and the stock market: The common shock case

This paper considers the consequences of employment protection with a fully diversified stock market when firms face a common shock. The analysis focuses on the interaction between employment protection and stock market when wages are sluggish or fixed. We build and calibrate a dynamic model where firms decide upon capital utilization, investment, vacancy posting and lay-offs in order to maximize shareholder value. Public policy, devoted to employment protection, is parametrized through firing costs. Due to the capital and employment irreversibilities, the model has to be solved using numerical techniques. Two series of scenarii are presented, first considering the effect of alternative level of firing costs i a benchmark economy, thus examining interactions between firing cost and successively, i) higher market price of risk, ii) higher separation rates, iii) fixed wages, iv) fixed capital utilization.