Endogenous Firing Costs and Labor Market Equilibrium

We explore the macroeconomic implications of the inverse relationship between firing costs and labor market tightness, evaluating its effects on labor market performance in a matching model `a la Mortensen and Pissarides (1994). Results are clear cut and generalizes our previous work. First, different configurations of the labor market structure deriving from the optimal behavior of the economic agents give rise to multiple equilibria: high average duration of unemployment will produce a labor market with low flows and wage and high strictness of employment protection. Vice versa, short duration in the unemployment status will produce high flows and wage and low level of firing costs. Furthermore, the endogeneity of firing costs and the positive externality they produce in the market is able to modify the nature of the steady state equilibrium. When the firing costs externality dominates the search costs externality, we show that the equilibrium is characterized by indeterminacy. Otherwise, when search costs are relevant, the equilibrium is a saddle point. Finally, endogenous firing costs also affect the determination of the social optimum, since it requires to internalize two kinds of externalities.