How do Lay‐off Costs Affect Employment?

Abstract

General equilibrium analyses of lay-off costs have had mixed messages on the implications for employment. This paper brings out the economic forces at work and sheds light on the disparate results. We explain why lay-off costs tend to increase employment in search models while the opposite is true in models with employment lotteries. In matching models, we show that the employment effects depend critically on how lay-off costs are assumed to enter the bargaining process. A common concern is that labour market rigidities such as lay-off costs are responsible for high European unemployment (OECD, 1994a). As documented by Emerson (1988) and Lazear (1990), lay-off costs are particularly burdensome in Europe. This paper explores a few general equilibrium models to see what kind of relationship there is between lay-off costs and an economy's level of employment. The analysis focuses solely on lay-off costs in isolation from other European labour market policies that might also influence unemployment rates such as minimum wages and generous unemployment compensation. As pointed out by Lazear (1990), any mandated severance pay can be offset by