European labour market institutions have long been blamed for the region's unemployment problem. But the theoretical and empirical research has not been too conclusive about the employment effects of these institutions. From a theoretical viewpoint, there may exist beneficial offsetting effects on employment of firing costs, minimum wages or unemployment benefits (Alogoskoufis et al (1995)); from an empirical viewpoint, the evidence is fragmentary and contradictory (Layard et al (1991)).

In Discussion Paper No. 1338, Research Fellow Gilles Saint-Paul develops a model to analyse the implications of firing costs on incentives for R&D and international specialization. The key idea is that, to avoid paying firing costs, the country with a rigid labour market will tend to produce relatively secure goods, at late stages in their product life cycles. With international trade, an international product cycle emerges where, roughly, new goods are first produced in the low-firing cost country, and then move to the high-firing cost country. The paper shows that in the closed economy, an increase in firing costs does not necessarily imply a reduction in R&D; it crucially depends on the riskiness of R&D activity relative to productive activity. In the open economy, however, an increase in firing costs is much more likely to reduce R&D intensity.