Many blame high firing costs for Europe's recent sustained high levels of unemployment, and some even advocate measures such as `flexible' contracts with short duration and low firing costs to stimulate labour demand. If firing costs are important and firms rely on voluntary quits to reduce their labour force, labour demand may be an increasing function of quits, which are themselves a decreasing function of unemployment. This can lead to multiple equilibria: low quits with high unemployment or high quits with low unemployment.

In Discussion Paper No. 670, Research Fellow Gilles Saint-Paul develops a model of labour demand incorporating uncertainty, endogenous wage formation through bargaining, and voluntary quits from low- to high-wage firms. There is a continuum of firms, each with a constant probability per period of becoming `obsolete', at which point profits fall to zero irrespective of production; but firing costs, which are assumed to be prohibitive, prevent their immediate closure and they are constrained to a `slow decline' through voluntary quits. Since the marginal value of labour is lower in `obsolete' firms, their workers look for jobs in productive firms, and most quits are from one employment to another. The quit rate is determined by the productive firm's employment level, which itself depends on the quit rate because of firing restrictions.
Saint-Paul finds there exist both high-unemployment, low-mobility and high-mobility, low-unemployment equilibria. In a depressed labour market, firing restrictions reduce the value of the firm and its demand for labour, since the obligation to retain unprofitable workers creates a positive feedback between labour demand and labour mobility. The high-employment equilibria are clearly preferable since all workers are better off, whether employed or unemployed, and a coordinated jump to the better equilibrium will increase the value of all firms. Policy measures can play a major role in shifting the economy to the better equilibrium, but their local effects will differ depending on the initial equilibrium. Where inadequate labour mobility causes the low-employment equilibrium, labour market policies can assume an important role.

Saint-Paul concludes by considering the impact of payments to workers that move between firms, since those in declining firms that allocate time to search for jobs in productive firms face some loss of earnings and change their flow probability. He finds that mobility premiums always increase aggregate output but may also increase unemployment, which may have undesirable distributional consequences. Mobility premiums increase the outflow from low- to high-productivity firms, which partly crowds out the shift of workers from unemployment to employment.

The High Unemployment Trap
Gilles Saint-Paul