Statutory redundancy pay was introduced in the UK with the passage of the 1965 Redundancy Payments Act and re-enacted in the 1978 Employment Protection Act. The aim of the legislation was to increase labour mobility, and to facilitate the replacement of inefficient old processes by growth-regenerating new ones. The emerging consensus on the impact of firing costs seems to be that they reduce the variability of employment over the business cycle but could potentially raise the level and persistence of unemployment.

In Discussion Paper No. 1101, Research Fellow Alison Booth and Gylfi Zoega derive a model in which workers have firm-specific and industry-specific skills, and in each period there is a non-zero probability that a worker quits. Market failures arise through the combination of quitting externalities, irreversible investments in human capital and repeated demand shocks. The quitting externality, which arises in labour markets with both specific and transferable training, has important consequences. It makes the private discount factor, used by firms in making decisions about hiring and training new workers and firing existing ones, higher than the social one. As a consequence, not only do firms underinvest in training but employment becomes too cyclical. Firms are too quick to dispose of their human capital in a cyclical downturn because it is of less value to them than it is to society. This provides a rationale for state-mandated redundancy payments as a second-best remedy to overcome the market failure.

Quitting Externalities, Employment Cyclicality and Firing Costs
Alison L Booth and Gylfi Zoega

Discussion Paper No. 1101, December 1994 (HR)