Many attribute high and persistent unemployment in the European economies to their highly regulated nature and in particular their restrictions on firms' dismissal of workers. The change from the high-growth, stable economic environment of the 1960s to low growth and high volatility in the 1970s and early 1980s may have made such restrictions more burdensome, making firms more reluctant to hire, but the empirical literature has not found a large impact of firing costs on labour demand.

In Discussion Paper No. 690, Samuel Bentolila and Research Fellow Gilles Saint-Paul develop a simple model of labour demand for firms facing stationary uncertainty, linear hiring costs and firing costs, together with transitory, serially independent shocks. The representative firm observes the current realization of the shock and then compares marginal profits from the current employment level with those arising from changing it, taking account of adjustment costs, and sets employment to maximize the present value of expected profits over an infinite horizon.

Their model indicates that the firm may optimally choose any of three courses of action: it fires workers to reduce employment in bad states of nature, keeps the labour force unchanged (allowing for quits) in intermediate states and hires up to a certain level in good states. With quadratic adjustment costs, optimal adjustments are made fully, not spread over time, so there is an `inaction range' or `corridor' defined by two bounds or threshold values of the productivity shock within which the firm will optimally keep employment unchanged.

An increase in firing costs from low values typically reduces labour demand, but it increases with firing costs that are sufficiently high, owing to changes in the contributions of the three types of firm to average labour demand. The `firing' edge of the inaction corridor reacts more strongly than the `hiring' edge to a rise in firing costs, but the fall in the former scarcely reduces the contribution of firing firms, while the rise in the latter boundary strongly reduces the contribution of hiring firms.

Bentolila and Saint-Paul also examine the cross-effects of the quit rate and firing costs to assess the view that inadequate labour mobility contributes to Europe's high unemployment by impeding labour shedding by declining firms. Reducing the quit rate raises labour demand if firing costs are low relative to hiring costs but reduces it if they are relatively high, while a rise in firing costs reduces labour demand more strongly when quits are lower.

A Model of Labour Demand with Linear Adjustment Costs
Samuel Bentolila and Gilles Saint-Paul

Discussion Paper No. 690, August 1992 (IM)