Firing Costs,Efficiency Wages and Unemployment

This paper uses a Shapiro–Stiglitz efficiency wage model to analyse the effects of firing costs on wages, employment, expected utility and profits. It considers that the probability of a non–shirker being fired depends on an exogenous shock which follows a two–state Markov process. It finds that higher severance payments give rise to lower wages, a lower unemployment rate, an increase in firms’ profits and a decrease in the utility of both workers and the unemployed. These conclusions derive from the finding that a greater probability of keeping one’s job, because of higher firing costs, raises the value of the job and reduces the worker’s incentives to behave opportunistically; this enables firms to reduce wages. Hence, if firms pay efficiency wages, a higher degree of labour market flexibility increases unemployment.