A pure theory of Job Security and Labor Income Risk

Models of labour market equilibrium where forward-looking decisions maximize both profits and labour income on a risk-neutral basis offer valuable insights into the effects of employment protection legislation. Since risk-neutral behaviour in the labour market presumes perfect insurance, however, job security provisions plays no useful role in such models. This paper studies a stylized model of dynamic labour market interactions where labour reallocation costs are partly financed by uninsured workers’ consumption flows. In the resulting second-best equilibrium, provisions that shift labour reallocation costs to risk-neutral employers can increase productive efficiency if their administrative dead-weight costs are not too large, and increase workers’ welfare as long as employers’ firing costs at least partly finance workers’ mobility.