Employment Protection and Unemployment Benefits: On Technology Adoption and Job Creation in a Matching Model

• Date: 01 July 2018
• Published date: 01 July 2018
• DOI: http://doi.org/10.1111/sjoe.12244

©The editors of The Scandinavian Journal of Economics 2017.

Scand. J. of Economics 120(3), 763–793, 2018

DOI: 10.1111/sjoe.12244

Employment Protection and Unemployment

Benefits: On Technology Adoption and Job

Creation in a Matching Model*

Kjell Erik Lommerud

University of Bergen, NO-5007 Bergen, Norway

kjell-erik.lommerud@uib.no

Odd Rune Straume†

University of Minho, 4710-057 Braga, Portugal

o.r.straume@eeg.uminho.pt

Steinar Vagstad

University of Bergen, NO-5007 Bergen, Norway

steinar.vagstad@uib.no

Abstract

We analyse the effects of different labour-market policies (employment protection,

unemployment benefits, and payroll taxes) on job creation and technology choices in a

model where firms are matched with workers of different productivity and wages are

determined by ex post bargaining. The model is characterized by two intertwined sources

of inefficiency, namely a matching externality and a hold-up externality associated with

the bargaining strength of workers. The results depend on the relative importance

of the two externalities and on worker risk aversion. “Flexicurity”, meaning low

employment protection and generous unemployment insurance, can be optimal if workers

are sufficiently risk-averse and the hold-up problem is relatively important.

Keywords: Flexicurity; unemployment insurance

JEL classification:H21; J38; J65; O31

I. Introduction

Here, we investigate theoretically optimal labour-market policies in a

matching-type model of the labour market. More precisely, we set up an

optimal taxation problem with three choice variables: an unemployment

*We thank an anonymous referee for very valuable comments and suggestions. O. R. Straume

acknowledges the financial support provided by the European Regional Development Fund

(ERDF) through the Operational Program Factors of Competitiveness (COMPETE); and by

national funds received through the Portuguese Foundation for Science andTechnology (FCT)

under the research grant PEst-C/EGE/UI3182/2013.

†Also affiliated with NIPE and University of Bergen.

764 Employment protection and unemployment benefits

benefit, a tax that can cause firing costs to increase or decrease, and a

payroll tax (or subsidy) on labour earnings. In the matching model we

employ, two sources of inefficiency interact. First, we envisage that some

match-specific investment in technology is undertaken before a job opening

is filled. When workers can capture quasi-rents from sunk investments,

this influences incentives both for technology investments and job creation.

The second source of inefficiency is the matching externality. The more

entrepreneurs who decide to start up a firm, the lower the probability that

a given firm is matched with a worker.

A key purpose of our analysis is to investigate the optimality of so-called

“flexicurity” policies in a context with inefficiencies in technology choices

and job creation, as described above. Among policymakers, flexicurity has

become something of a buzzword. Can one make relatively rigid labour

markets in parts of Europe more prone to change, while still preserving

the economic safety net that to some extent is absent in the US? The

concrete idea is to decrease employment protection, but at the same

time provide economic security outside the original firm by supplying

generous unemployment benefits and retraining support. Denmark and

the Netherlands are countries where flexicurity purportedly exists, and

these countries have experienced smaller unemployment problems than

many other European economies over the last years. In the context of

our theoretical framework, flexicurity is taken to mean a situation where

unemployment benefits are combined with low (or zero) employment

protection, while the payroll tax is used to balance public budgets.

It is not obvious that a flexicurity type package of policies would be

sensible in the current setting. Technology investments are seen as (at least

partly) firm–worker specific (e.g., due to training and adoption costs).1The

presence of sunk and match-specific technology investments casts doubt

on the extent to which a policy with lower firing costs, to induce mobility,

is the correct one. Maintaining an existing relationship between the firm

and the worker has value. However, even in this framework, some workers

will not find employment. Some are unlucky and not matched. Some lose

their job because their productivity turns out to be very low. These workers

demand unemployment insurance, and the more risk-averse they are the

more so. Unemployment benefits strengthen the outside option for workers

and influence how rents are shared inside firms. The ex post bargained

wage is driven up, and more so the higher the bargaining strength of

1What we, for simplicity, dub “technology” investments can be seen as a mix of technology

investments and firm-sponsored worker training necessary to employ the new technology. This

creates a lock-in and a struggle for the division of rents. The model could have included

training costs paid by the workers, but this would not change the main course of the analysis.

©The editors of The Scandinavian Journal of Economics 2017.