Severance Payments as a Commitment Device

Abstract

The present paper analyzes the role of severance payments in optimal labor contracts, employing an efficiency-wage model with two-sided moral hazard. We show how employers commit to job security for their workers by using severance payments, but that in general, employees are not fully compensated for the loss in income in the event of a layoff. By extending the analysis we establish a positive relation between investment in firm-specific training and the probability that a worker dismissed for behavioral reasons receives severance payments, and suggest that a mandatory increase in severance payments may yield a Pareto improvement.