The Layoff Rat Race

Abstract

We investigate how discretionary investments in general and specific human capital are affected by the possibility of layoffs. After investments are made, firms may have to lay off workers, and will do so in inverse order of the profit that each worker generates. General human capital investments lead to higher wages, but firms extract less rents from such investments, and hence tend to lay off workers who invest less in specific human capital first. In equilibrium, to reduce layoff probabilities, workers may invest in specific human capital even if they are not compensated directly for that skill investment. We characterize how equilibrium skill investments are affected by the distribution of worker abilities within firms, and the probability a firm downsizes. In bargaining settings, even though workers only receive a share of any investment, fear of layoff causes workers to over-invest in skill acquisition from a social perspective if their bargaining power is strong enough. Our analysis can reconcile the paradoxical observation that in regions with high unemployment rates, workers are highly specialized with low levels of general training.