Employment protection and aggregate unemployment

Abstract

The effects on the aggregate unemployment rate of employment protection provisions has been the subject of considerable debate. This paper shows that if firms pay efficiency wages to encourage effort in the workplace, the effect of increasing employment security is to increase the equilibrium wage but not necessarily to increase unemployment. It is possible that worker effort falls to such an extent that firms must employ more workers to produce a smaller output so that tightening employment protection actually reduces unemployment. The model used is based on the paper by Shapiro and Stiglitz (1984) in which unemployment serves as a “worker-discipline device.”