Alternative Labor Retrenchment Laws and Their Effect on Wages and Employment: A Theoretical Investigation with Special Reference to Developing Countries

Abstract

Many countries have legislation which makes it costly for firms to dismiss or retrench workers. In the case of India, the Industrial Disputes Act, 1947, requires firms that employ 100 or more workers to seek prior permission from government before retrenching workers. This paper builds a theoretical model to analyze the effects of such anti-retrenchment laws. Our model reveals that an anti-retrenchment law can cause wages and employment to rise or fall, depending on the parametric conditions prevailing in the market. We then use this simple model to isolate conditions under which an anti-retrenchment law raises wages and employment. In a subsequent section we assume that the law specifies exogenously the amount of compensation, s, that a firm has to pay each worker who is being dismissed. It is then shown that as s rises, starting from zero, equilibrium wages fall. However beyond a certain point, further rises in s cause wages to rise. In other words, the relation between the exogenously specified cost to the firm of dismissing a worker and the equilibrium wage is V-shaped.

Keywords: Labor Laws, Retrenchment, Severance Pay, Employment

JEL Classification: O15, O17, J32, J63