Labor Market Performance and Flexibility: Which Comes First?

Abstract We use a matching framework to explore the hypothesis that firing costs are a decreasing function of labor market tightness. Conventional wisdom suggests that differences in employment protection legislation (EPL) cause differences in labor market performance. Our hypothesis suggests a reverse causality nexus: it is labor market tightness which causes labor market rigidities. The endogeneity of firing costs produces a positive externality. We show that if this externality offsets the standard search externality, the model generates multiple equilibria. which reflect a trade off between wage moderation and the strictness of EPL. We demonstrate that the equilibria are not Pareto ranked. The analysis of local stability shows that, when firing costs externality offsets the search cost externality, the equilibrium is a stable node; vice versa, the equilibrium is an unstable saddle point. Finally, we investigate the question of social efficiency, obtaining a generalization of the Hosios (1990) condition.