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The effects of firing costs on the wage contracts under adverse selection

Listed author(s):
  • Anne Bucher
  • Sébastien Ménard

We develop a two-period principal-agent model to investigate the effects of firing costs on self-selection mechanisms and on the optimal wage contracts under adverse selection. There are two types of risk-averse workers who differ by their ability. The worker’s ability is private information but revealed once engaged in production. The adverse selection problem may be solve by workers’ selection from a menu of separating contracts that specifies a sequence of wages with dismissal being the only form of punishment to a worker who overstated his ability. We find that as firing costs increase, the wage-tenure profile of high-ability workers gets steeper while the information rent left to low-ability workers vanishes. For higher levels of firing costs, an incentive menu of contracts provides the most able workers with a lower starting wage than the less able workers. As the expected profit from separating contracts decreases with dismissal costs, there exists a threshold above which the employer prefers to offer a pooling wage that might drive good workers out of the labor market.

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File URL: http://www.beta-umr7522.fr/productions/publications/2015/2015-17.pdf
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Paper provided by Bureau d'Economie Théorique et Appliquée, UDS, Strasbourg in its series Working Papers of BETA with number 2015-17.

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Date of creation: 2015
Handle: RePEc:ulp:sbbeta:2015-17
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  1. Hagedorn, Marcus & Kaul, Ashok & Mennel, Tim, 2010. "An adverse selection model of optimal unemployment insurance," Journal of Economic Dynamics and Control, Elsevier, vol. 34(3), pages 490-502, March.
  2. Pedro Portugal & Olivier Blanchard, 2001. "What Hides Behind an Unemployment Rate: Comparing Portuguese and U.S. Labor Markets," American Economic Review, American Economic Association, vol. 91(1), pages 187-207, March.
  3. Bassanini, Andrea & Garnero, Andrea, 2013. "Dismissal protection and worker flows in OECD countries: Evidence from cross-country/cross-industry data," Labour Economics, Elsevier, vol. 21(C), pages 25-41.
  4. Oyer, Paul & Schaefer, Scott, 2005. "Why do some firms give stock options to all employees?: An empirical examination of alternative theories," Journal of Financial Economics, Elsevier, vol. 76(1), pages 99-133, April.
  5. Samuel Bentolila & Giuseppe Bertola, 1990. "Firing Costs and Labour Demand: How Bad is Eurosclerosis?," Review of Economic Studies, Oxford University Press, vol. 57(3), pages 381-402.
  6. Lisa B. Kahn, 2013. "Asymmetric Information between Employers," American Economic Journal: Applied Economics, American Economic Association, vol. 5(4), pages 165-205, October.
  7. Adriana D. Kugler & Gilles Saint-Paul, 2004. "How Do Firing Costs Affect Worker Flows in a World with Adverse Selection?," Journal of Labor Economics, University of Chicago Press, vol. 22(3), pages 553-584, July.
  8. Blien, Uwe & Messmann, Susanne & Trappmann, Mark, 2012. "Do reservation wages react to regional unemployment?," IAB Discussion Paper 201222, Institut für Arbeitsmarkt- und Berufsforschung (IAB), Nürnberg [Institute for Employment Research, Nuremberg, Germany].
  9. Milton Harris & Bengt Holmstrom, 1982. "A Theory of Wage Dynamics," Review of Economic Studies, Oxford University Press, vol. 49(3), pages 315-333.
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