Optimal incomplete contracts in a matching model

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IZA Seminar

Place: Schaumburg-Lippe-Str. 9, 53113 Bonn

Date: 30.04.2002, 12:15 - 13:30


Presentation by 

Giulio Fella (Queen Mary, University of London)


We analyse a matching model of unemployment in which risk-averse workers cannot access capital markets. When a match is formed, workers bargain with risk-neutral firms over incomplete insurance contracts featuring state-independent wages and severance pay. We allow for ex post renegotiation by mutual consent. We show that even with incomplete markets, the causal link from high mandated job security to labour market distortions is tenuous. Firing costs well in excess of privately optimal ones have negligible effects on the unemployment rate and efficiency. If separation is mutually beneficial, a firm-worker pair has always an incentive to renegotiate excessive mandated job security by relabelling a separation as a quit. Conversely, optimal private contracts require high severance payments when low unemployment benefit replacement ratios and high bargaining power and rents on the part of workers imply that job loss is associated with large income fluctuations. We provide empirical evidence of a positive (negative) relationship between a measure of job security and an index of union power (benefit replacement ratios).

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