How do Lay‐off Costs Affect Employment?

Abstract

General equilibrium analyses of layoff costs have had mixed messages on the implications\nfor employment. This paper brings out the economic forces at work and explains the\ndisparate results. Specifically, we show that positive employment effects of layoff costs come\nthrough reducing labor reallocation, whereas negative effects come through reducing the\nprivate return to work due to those layoff costs and the associated inefficient allocation of\nlabor. Additional adverse employment effects can arise through an increase in the effective\nbargaining strength of workers. These forces explain why layoff costs tend to increase\nemployment in search models while the opposite is true in models with employment lotteries.\nIn matching models, we show that the employment effects depend critically on how layoff\ncosts are assumed to enter the bargaining process.

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