_{1}

In this paper, we develop a matching model with both permanent and temporary contracts to address situations in which the quality of a match formed by a worker-firm pair is not observable to both workers and firms. The screening and cost-saving aspects of temporary employment contracts are two primary reasons that firms use them, but screening has received little attention in the study of employment protection. We show that increasing dismissal costs decreases job creation and that higher dismissal costs are likely to reduce the hiring threshold for temporary jobs and raise the threshold for permanent jobs. We also examine how changes in dismissal costs affect the average productivity of permanent jobs and discuss the effectiveness of the policy of increasing labour market flexibility by weakening firing restrictions for permanent employment.

One of the most important recent topics in labour economics is the issue of how employment protection legislation affects labour markets. In Europe, high and persistent unemployment rates (compared with those in the US) are thought to result from stringent employment protection that has generated labour market rigidities. In the 1980s, many European countries addressed this problem by liberalising the use of temporary contracts, with the aim of combating unemployment. However, introducing flexible employment contracts into economies with high unemployment produced only inconclusive results and remains theoretically and empirically controversial. Theoretical models predict that more stringent employment protection reduces both job creation and job destruction, which makes the overall effect on employment (and unemployment) ambiguous. This effect may imply that more flexible regulation of temporary employment may create new jobs but that these jobs are not well protected by employment legislation and are therefore unstable. In certain cases, the latter effect dominates the former, and the unemployment rate rises (see [

How the policies of easing the use of temporary contracts or relaxing other employment protection legislation affect labour markets depends on employers’ hiring strategies regarding the types of contracts. There are a number of reasons that employers use fixed-term employment contracts. [^{1} The evidence that temporary work can be a stepping stone to permanent work suggests that a screening effect is being exploited by firms with respect to temporary workers. Although a number of studies have incorporated the distinction between contract types into theoretical models that examine the effects of employment protection legislation on labour markets, the screening role of temporary contracts has not been a main focus of research attention. [^{2} Thus, the purpose of this paper is to theoretically examine how employment protection for permanent jobs affects firms’ hiring decisions and the screening function of temporary contracts when the quality of an employment match (the productivity of a worker-firm pair) is match-specific and not perfectly observable.

The equilibrium search model is helpful in studying the effects of employment protection when both permanent and temporary jobs are considered. In particular, the endogenous job destruction framework constructed by [^{3}

The present paper has a motivation similar to that of [^{4} [^{5} [

Although the motivation for this paper is similar to that of [^{6} As noted by [^{7} and show that the types of contracts chosen depend on the realised value of the observed signal of a match type. Because research regarding the choice between temporary and permanent jobs (combined with the screening role of temporary jobs) is limited, our paper offers new insights into the impact of employment protection. Furthermore, because this paper theoretically shows the unique existence of an equilibrium with the endogenous choice of contract type, we are able to qualitatively examine the effect of dismissal costs on hiring standards and the average productivity of permanent jobs and to discuss the effectiveness of the policy of increasing labour market flexibility by weakening firing restrictions for permanent employment.

We further note that the average productivity of permanent jobs is one of the major factors in the analysis of this paper because if temporary contracts are an effective tool for screening workers for permanent positions, employers will expect increased productivity in permanent jobs. Because multiple mechanisms (substitution between general and firm-specific skills, work effort, substitution between permanent and temporary employment, and selection of workers) generally contribute to the effect of employment protection legislation on productivity, it is difficult to address all of these factors in one specific model.^{8} Among others, [

One important limitation of our work is that a welfare analysis is not conducted. The major reasons for this are: 1) it is difficult to obtain the analytically clear-cut result regarding how a change in dismissal costs affects the social welfare; and 2) we focus on the employers’ decision on what type of contract to offer. However, whether to increase dismissal costs or to decrease them should be determined from the viewpoint of social efficiency. In this regard, a detailed numerical analysis is required.

The remainder of the paper is organised as follows. In Section 2, the basic framework of the model is described. In Section 3, a steady-state equilibrium is characterised. In Section 4, we investigate how dismissal costs affect job creation and the hiring thresholds for each type of contract. Finally, Section 5 concludes.

We extend the model studied by [

This model explicitly includes labour market friction; therefore, job seeking and recruiting activities are time consuming. We assume that the meeting process is described by constant-returns-to-scale matching technology,

The production technology and the learning processes regarding match quality are based on [^{9} As in the above literature, match-specific productivity is observed at the end of the period; it is represented by

Match quality is considered to be both an inspection and an experience good. When a job seeker and a vacant firm meet, they observe a signal

In this model, two types of contracts are considered: temporary and permanent. In addition, there are two states of permanent contracts: pre-existing and newly created. When pre-existing permanent workers are dismissed, firms must pay fixed dismissal costs (firing taxes)^{10}

Separations from permanent jobs occur (i) when the match quality is revealed to be bad or (ii) when each firm experiences the negative shock with constant probability

To derive the values of firms with each type of contract, some notation must be defined. Let us denote the value of a firm with a temporary job and a signal

The expected value of a firm that has a temporary job and a signal

where

Then, Equation (1) is a special case of (1’) when^{11} For comparison, if the last term

The expected value of a firm with a permanent job and signal

where

The expected value of a vacant firm is represented by

where c denotes the flow recruiting costs and

Let us denote the value of being employed in a temporary job with signal

where

The expected value of being employed in a permanent job with signal

and the expected value of being unemployed is represented as follows:

Let us define the joint surplus generated from forming a match as follows:

where each equation is evaluated at any

Using these sharing rules, we derive the expressions for joint surplus as follows. First, the joint surplus values for permanent jobs are given by

where we use the free-entry condition that the values of vacancies in each state are equal to zero:

We first consider the hiring decisions of firms with permanent jobs. Because firms can choose a form of contract with no cost, a firm decides to hire a worker on a permanent basis if offering a permanent contract is more profitable than offering a temporary contract. The corresponding condition for determining the optimal hiring standard is given by

Utilising (9), (10) and (12), the following two results are derived:

The first result depicts the relationship between

This automatically holds under the assumption provided in Proposition 1.

We assume that ^{12}

We next consider the existence of

and the condition

This results in

Subsequently, (11) yields the explicit form of

Because

This condition requires that ^{13} Otherwise, even if the true productivity is

For the value of a

Proposition 1. There exists a unique

Furthermore,

Proof. See Appendix A.

Condition (20) is required for the presence of^{14} This case is obtained for a sufficiently large d. In this case,

The determination of hiring thresholds is described in

We further note that

The measure of vacant jobs that is posted in equilibrium is determined by the free-entry condition. Equation (4),

with

where

The LHS of (21) increases in

From (15),

Regarding the first two results, increased market tightness reduces the meeting probability of employers; therefore, employers raise their hiring thresholds to ensure profits. Taking from (16) that

Proposition 2. There exists a unique value of ^{15}

As observed by [

Let us denote the steady-state measure of permanent workers by

The equivalence of the inflow and outflow from the employment pool of temporary contracts yields the following condition:

The LHS of (22) reflects the assumption that every temporary contract is terminated in the next period and that each temporary worker will be either employed with a permanent contract or unemployed. Regarding the RHS of (22), only worker-firm pairs that realise a signal contained in

In the pool of high-quality employment, the equivalence of the inflows and outflows yields

where

The LHS of (23) indicates that a negative shock, which occurs with probability

In the employment pool of permanent jobs with unknown productivity, the following equivalence condition is obtained:

In the LHS of (26), outflows from this employment pool result from negative economic shocks and the revelation of matches that are either low or high productivity. The RHS of (26) captures inflows into this pool; it is composed of newly formed matches with signals that exceed

Together with two additional conditions,

(22), (23) and (26)-(28) determine the steady-state value of

where

Because the surplus sharing rules have already been derived, we are able to solve the Nash wage equations for each type of employment contract. From (4) and (8), the wage equations for temporary contracts are given by

Similarly, it follows from (5) and (7) that the wage equations for permanent contracts of type I are given by

Note that wages do not play a crucial role in the characterisation of the steady-state equilibrium because wages in both types of jobs are determined by the standard Nash bargaining problem and it is sufficient to focus on the surplus sharing rules given by (7) and (8).

The steady-state equilibrium in this model is characterised by

To examine the effects of dismissal costs on firms’ hiring decisions in a steady-state equilibrium, we first consider how these costs affect labour market tightness. For that purpose, the effects of d on the hiring thresholds must be identified. It follows from (15) and (18) that for a given

where

From (17’), a change in d has the following effect on

where

Although (38) is somewhat complex, we are able to identify its sign explicitly. The result is summarised in the following Lemma.

Lemma 1. An increase in dismissal costs raises

Proof. See Appendix B.

We provide the same interpretation as in the case of

From (37) and Lemma 1, we obtain the following proposition regarding the effect of dismissal costs on job creation.

Proposition 3. The sign of (39) is negative and

Proof. See Appendix C.

For a higher

The result obtained in Proposition 3 may be standard and intuitive. However, the main focus of this paper lies in how the costs of firing employees affect employers’ hiring policies. At first glance, it appears to be difficult to obtain clear-cut results regarding the effect of dismissal costs on hiring thresholds,

Proposition 4. Suppose that

Then, increasing dismissal costs for permanent jobs raises the hiring threshold

Proof. See Appendix D.

We will provide a graphical explanation of Proposition 4 based on

The signs of these equations depend on the magnitude of

Remembering that Proposition 3 is likely to hold under a higher value of

Proposition 5. Increasing dismissal costs for permanent jobs decreases

and (ii) the expected costs of a vacancy are less affected by a change in

Proof. See Appendix E.

Although the effect of d on the slope of

It is worth noting that changes in dismissal costs have different impacts on hiring thresholds between permanent and temporary contracts under similar conditions on z (match productivity is more dispersed). As noted in (37) and Lemma 1, a direct impact of d on each hiring threshold is positive for a given^{16}

First, we focus on the hiring threshold for temporary contracts. For a given

Second, regarding the hiring threshold for permanent contracts, note that

Because this paper focuses on the screening role of temporary contracts, we have an interest in the impact of dismissal costs on the screening function of temporary contracts from the viewpoint of firms. In this regard, the average productivity of permanent jobs will be appropriate. If temporary contracts are effectively used as screening devices and potentially unproductive matches are eliminated, employers will expect an increase in the productivity of permanent jobs. Using the results regarding the effect of d on

We first define the average productivity of permanent jobs as follows:

where

There are two types of permanent jobs: (i) the true match quality is good; (ii) the true match quality is not revealed. Note that the productivity of the latter type is expressed using

Proposition 6. Suppose that the results of Proposition 4 and Proposition 5 hold. Then, increasing firing costs for permanent jobs increases their average productivity.

Proof. See Appendix F.

This proposition shows that higher dismissal costs improve the average productivity of permanent jobs because of (i) the increased proportion of good-quality jobs among permanent jobs

We here examine how the dismissal costs for permanent jobs affect the average productivity of temporary jobs and the ratio of temporary employment. Regarding the average productivity of temporary jobs, we obtain the following proposition:

Proposition 7. An increase in dismissal costs has an ambiguous impact on the average productivity of temporary jobs.

Proof. See Appendix G.

The reason for this result is that increasing dismissal costs has two opposite effects: a decline in the hiring threshold for temporary jobs and an increase in the hiring threshold for permanent jobs. The former effect results in the decreased average productivity of temporary jobs, whereas the latter effect helps to increase average productivity. Therefore, a change in average productivity depends on which effect overcomes the other.

Furthermore, it follows from (30) and (31) that the relative ratio of temporary employment is expressed by

where

Simple calculations show that an increase in d increases this ratio. Therefore, higher firing costs for permanent jobs increase the proportion of temporary employment. This result is consistent with the finding by [

The qualitative analysis conducted in this paper suggests that reducing dismissal costs for permanent jobs increases job creation and the proportion of permanent employment when match productivity is more dispersed (z is large). Using a similar framework, [^{17} Although policies of easing employment protection for permanent jobs appear to be problematic because of political pressure from permanent workers (see [^{18} However, we should emphasise that Proposition 6 suggests that the favourable effects of weakening employment protection for permanent jobs will be in exchange for reducing the average productivity of permanent jobs when match productivity is more dispersed. In other words, if temporary contracts are expected to screen workers before they are promoted to permanent employment, increasing labour market flexibility by reducing dismissal costs for permanent jobs makes this screening role less significant because employers become less selective in hiring workers as permanent employment and the proportion of matches with unknown productivity increases.

We finally note the finding of [

This paper has examined how the employment protection of permanent contracts affects employers’ hiring decisions if the true productivity of a worker-firm pair is not fully revealed even after a match is formed. We incorporate permanent and temporary contracts into an equilibrium search model and consider a situation in which temporary contracts are used to screen workers for permanent positions. Although employers cannot accurately observe the true quality of a match, they receive an observable signal about the quality of the match when hiring a worker. Employers’ hiring decisions are based on the realisation of this signal and are characterised as the determination of the hiring thresholds. The innovative point of this paper is that employers’ choice of what type of contract to offer is endogenous. This enables us to specify the hiring threshold for each type of employment contract and to analytically examine the impact of a change in dismissal costs on each threshold and labor productivity.

The main results obtained in this paper are summarised as follows. First, there exists a unique steady-state equilibrium in which employers have an incentive to offer permanent contracts and both permanent and temporary jobs exist concurrently. Second, reducing dismissal costs for permanent jobs increases job creation. Third, higher dismissal costs reduce the hiring threshold for temporary jobs and raise the threshold for permanent jobs, which implies that employers will be more (less) selective in hiring workers for permanent (temporary) employment when dismissal costs increase. We also note that the responses to these hiring thresholds occur under a high degree of uncertainty about the more true quality of job matches. In this situation, temporary contracts are likely to be used as screening devices, and therefore, the impact of dismissal costs varies between permanent and temporary contracts. Fourth, increasing dismissal costs increases the average productivity of permanent jobs when the hiring threshold for temporary jobs is reduced and that for permanent jobs is raised. These results imply that increasing labour market flexibility by reducing dismissal costs for permanent jobs has an adverse effect of reducing the screening function of temporary contracts and lowering the average productivity of permanent jobs, whereas this policy appears to have favourable effects such as fostering job creation and increasing the proportion of permanent workers.

I thank the Editor and the referee for their comments. I am also very grateful to Hiroaki Miyamoto and the participants in the Search Theory Workshop at Hokkaido University and the 26-th EALE conference in Ljubljana for their helpful comments. This work was partly supported by JSPS KAKENHI Grant Number 29014289. All remaining errors are mine.

Makoto Masui, (2016) Employment Protection, Employers’ Hiring Strategies and the Screening Role of Temporary Contracts. Modern Economy,07,758-785. doi: 10.4236/me.2016.77080

We prove the statements of the proposition by relying on the following three facts: (i)

First, it follows from (12) and (16) that

If (19) is satisfied, the first term in (A-1) and the overall sign of (A-1) are negative.

Second, from (11), we obtain

We note that from (13) and (15),

Substituting (A-3) into (A-2) and arranging it yield

This takes a non-negative value if (20) holds. Since both

Finally, we will show that ^{19} Evaluating (9) by

We can show that the first term of the brace in (A-5) is less than one. Because the second term of the brace in (A-5) is obviously greater than one, the overall sign of (A-5) is negative. This indicates that

We first show that the coefficient of the last term of the brace in (38) is less than one. Actually, we obtain

We also note that the following inequality stems from (20):

Thus the sum of the first and the last terms in the brace of (38) has a positive sign and the overall sign of (38) is also positive. The proof is complete.

Appendix C. Proof of Proposition 3The second term of (39) takes a negative value from Lemma 1 and

Under the fact that

Recalling that the LHS of (21) is increasing and the RHS of (21) is decreasing in

We first note that the following facts are obtained for a given

(i) (17’) yields

where

Arranging the terms in the brace of the above equation results in

(ii) It follows from (38) that we obtain

where

(iii) The expressions of

(iv) It follows from (18) that we obtain

where it follows from (15) that

(v) (37) yields

(vi) Focusing on the RHS of (21), the impact of

and the impact of d on the RHS of (21) for a given

where expressions in subsection 3.2 yield

From (D-7) and (D-8),

At this stage, we are now ready for examining the overall effect of d on

The numerator of (D-11) is given by

In this equation, note that the first term of (D-12) takes a negative sign because of the result of Lemma 1 and

We then focus on the square brackets of the second and the third term of (D-12). Regarding the second term, it follows from (D-3) and (D-9) that we obtain

Using (D-1) and (D-2), this expression is rewritten as

Since a sign of (D-13) depends on a sign of its second line, we will specify the condition which makes the latter positive. Arranging the second line of (D-13) yields

In the derivation of the second line, we have used the fact that the expression

around

Using the definition of

Regarding the square bracket of the third term of (D-12), it follows from (D-1), (D-2), (D-5) and (D-6) that we obtain

Arranging the terms in the brace of (D-16) yields

The coefficient of

Substituting this into (D-17) yields

To identify a sign of (D-18), we first compare the term in the second brace of the first line with the coefficient of the second line:

where we have used the fact that

Using the definition of

Since (41) ensures that the denominator of (D-19’) takes a positive sign, (D-19’) (equivalently, (D-19)) is redundant.

Second, comparing the term in the first brace of the first line of (D-18) with the term in the brace of its second line yields

This takes a non-negative sign if

Using the definition of

Therefore, under the conditions (D-15), (D-19) and (D-20), (D-12) takes a negative sign.^{20} Then, we conclude that an increase in dismissal costs for permanent jobs raises the hiring threshold of permanent jobs (recall that the denominator of (D-11) is equivalent to that of (D-10) and its sign is negative). The proof is complete.

The overall effect of d on

Its numerator is written by

First, it follows from (D-3), (D-5), (D-6) and (D-9) that the terms in the parenthesis of the second term in (E-1) are given by

This takes a positive sign if the following condition holds:

Second, it follows from (D-1), (D-2), (D-5) and (D-6) that the terms in the parenthesis of the third term in (E-1) are given by

In (E-3), the coefficient of

Substituting this expression into the brace in (E-3) yields

We first specify the condition which makes the following expression positive:

A sign of (E-5) becomes non-negative if the following condition is satisfied:

Since the condition (20) is more binding than (E-6), this condition is redundant. Subsequently, we examine a sign of the following expression from (E-4) and obtain the condition which makes it non-negative:

Since ^{21} Rewriting (E-7) by using the definition of

Finally, we consider the impact of the first and the last term of (E-1). Regarding the first term, it has a smaller impact on (E-1) if (i) the expected costs of having a vacancy are less affected by a change in

where the last line of (E-8) takes a positive sign if the following inequality holds:

Regarding the last term of (E-1), we note that the impact of

Together with fact that the direct impact of d on

Let us define the conditional expectations of

and let us define

Using (F-1) and (F-2), the average productivity of permanent jobs is expressed by

To examine the effect of d on (F-3), we focus on the effect of d on

where

It follows from these facts and (F-4) that

A sign of (F-5) is positive if

We next examine how an increase in d affects

Using (F-3), (F-5) and (F-6), we conclude that an increase in d increases the average productivity of permanent jobs. The proof is complete.

Appendix G. Proof of Proposition 7The average productivity of temporary jobs is represented by

where the expression of

Note that the square bracket in the first line has a positive sign, while the square bracket in the second line has a negative sign. Using the results obtained in Proposition 4 and Proposition 5, the overall sign of (G-1) is indeterminate. The proof is complete.

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