Compulsory Job Security and Unemployment

Abstract

This paper explores the hypothesis that replacing the employment at will doctrine with job security legislation will increase unemployment. It begins by discussing the casual correlations that can be found between nations with aggressive job security legislation and nations that face chronic unemployment problems. In Europe, for example, employer surveys suggest that restrictions on employment termination are most severe in Italy and Spain, moderately severe in France and Germany, and relatively moderate in the United Kingdom, Denmark, and Ireland. Unemployment rates track these categories fairly closely.

The paper then explores the theoretical linkage between job security legislation and unemployment. It is clear that job security laws can operate as a tax on employment, as it may lead to shirking, to administrative costs of bureaucratizing the workforce, and to litigation costs. The theoretical challenge, however, is to explain why this tax on employment should result in a reduction in employment as opposed to simply a drop in wage rates. The paper offers two explanations for this, one based on efficiency wage theory and one based on insider-outsider theories of unemployment.

Under efficiency wage theory, the average quality of labor declines as the wage rate declines. If this effect is large enough, firms may find it unprofitable to lower wages to pick up the labor efforts of the unemployed. There are adverse selection and moral hazard reasons for the efficiency wage effect. The adverse selection problem is that employees may have private knowledge about their own productivity or proclivity for shirking, and employers fear that low-wage policies will attract lemon employees. Job security legislation exacerbates this problem, as firms who realize they will have a tough time firing poor employees must be especially careful about whom they hire up front, leading to larger wage premiums. The moral hazard problem is that employees may lose their incentive to act in the principal's interest if they are not paid a premium over the market wage. Job security legislation exacerbates this problem because when employees realize their chances of being fired upon shirking have decreased, the wage premium they will forfeit by shirking and being fired must be made larger than before to work as an incentive.

The insider-outsider theory posits that unemployment is brought about by the ability of incumbent employees to exploit the transaction costs of changing employees. Job security legislation directly enhances the transaction cost of changing employees, thus making it easier for incumbent employees, whether individually, through an actual union, or through a threat to unionize, to raise their wages. Job security legislation also makes it easier for employees to carry out strategies that are designed to increase the employer's cost of changing employees, such as harassing or refusing to cooperate with new employees in training, as employees pursuing such strategies will be less likely to be fired.

JEL Classification: J64, J68