Fixed-Term and Permanent Employment Contracts: Theory and Evidence

This paper constructs a theory of the coexistence of fixed-term and permanent employment contracts in an environment with ex-ante identical workers and employers. Workers under fixed-term contracts can be dismissed at no cost while permanent employees enjoy labor protection. In a labor market characterized by search and matching frictions, firms find it optimal to discriminate by offering some workers a fixed-term contract while offering other workers a permanent contract. Match-specific quality between a worker and a firm determines the type of contract offered. We analytically characterize the firmâs hiring and firing rules. Using matched employer-employee data from Canada, we estimate the modelâs parameters. The effects of firing costs on wage inequality vary dramatically depending on whether search externalities are taken or not into account.