A Dynamic Model of the Value of Labor Force Flexibility

Abstract

The paper analyzes the benefits of retaining flexibility in a firm s hiring practices by building on Pindyck s (1988) model of irreversible investment. Two types of workers (contracts) are allowed to co-exist: permanent workers, who cannot be fired, and temporary ones, who are hired and fired according to current needs. The latter are less productive (more expensive per unit of output), but allow the firm flexibility in adjusting to demand downturns. We apply this model to investigate the optimal composition of the labor force, and study how it varies with characteristics of the firm s market. The results we obtain are consistent with the stylized facts in the literature on labor market practices in the U.S. and Japan. We also examine the cost of the lifetime employment contract relative to the optimal mix of lifetime and temporary contracts, i.e. the magnitude of the value of flexibility.

JEL Classification: J21