A Real Options Analysis of Dual Labor Markets and the Single Labor Contract

Abstract

We study the hiring and firing decisions of a firm in a Dual Labor market and in a Single Labor Contract. Under both regulations, to fire before a certain seniority threshold is similar to an American option that gives the right of firing at low costs. However, the value of the option is different in each regulation. Our model takes into account the value of this option to analyze a firm's firing and hiring behavior. We study the role of the firm's risk aversion, and of the growth and volatility of the firm's profits. In our model the maximum allowed duration of temporary contracts is deterministic. Three channels drive the firing decisions: 1) A substitution effect to replace existing workers with new hires with lower firing costs; 2) An anticipation effect in which the expectations of increasing firing costs pushes towards early firing; and 3) The value of the option to fire at low costs. Our main results are: 1) In the Dual regulation most of firing happens just before the worker becomes permanent. 2) The Single Contract implies higher expected duration at the job, less job churning and less unemployment. However, in the Single Contract, workers that are fired are fired sooner, and permanent workers are more likely to be fired.