Employment_protection_&_unemployment

March 1998
The second factor often mentioned in discussions of European unemployment is
employment protection (the first, unernploymenr benefits, was the topic of the
previous note). Employment protection, the argument goes, increases the cost of
doing business, leads to sclerosis of the economy, and to high unemployment. The
purpose of this note is to assess both the theoretical and the empirical merits of
the case.
Employment protection has two dimensions. The first, severance pay, is a transfer
for the firm to the worker it wants to layoff. The second is a set of administrative
restrictions and procedures that the firm has to obey if it wants to layoff a worker;
these range from the need for prior authorization, to a notice period, to an appeal
procedure for workers. Together, these can amount to a large cost in time and
money, a cost often larger than the transfer itself.
From a theoretical point of view, the distinction between the transfer and the cost
components is an important one. The transfer is not a cost to the firm-worker pair,
and, in principle, its effects can be offset by the pair, in effect by a reverse transfer
from the worker to the firm at the start of the employment decision, a transfer refered
to “bonding” in the literature. But the effects of the cost component, which
represents a cost to the firm-worker pair, cannot be so undone. In practice, the
scope for bonding may be limited, so that the transfer and the cost components
may have roughly similar effects on employment and wages1