Dual Labor Markets and the Equilibrium Distribution of Firms

We study how the co-existence of fixed-term (FT) and open-ended (OE) contracts shapes firm dynamics, firm selection, worker allocation, aggregate productivity, and output. Using rich Spanish administrative data, we document that the use of fixed-term contracts is very heterogeneous across firms within narrowly defined sectors. Particularly, the relationship between the share of temporary workers and firm size is positive within firms but negative between firms. To explain these facts, we write a model of firm dynamics with technology heterogeneity, search-and-matching frictions, and a two-tier labor market structure. Our model emphasizes a key trade-off between contracts, namely, that while FT contracts give flexibility to firms, they also create more worker turnover, which is costly through the need to hire new workers and through the loss of firm-specific human capital. We find that limiting the use of FT contracts decreases the share of temporary employment and increases aggregate productivity --as better firm selection offsets increased misallocation of workers-- but it also increases unemployment, output, and welfare.