School of Economics and Finance

No. 400: When Do Firing Costs Matter?

Giulio Fella , Queen Mary and Westfield College, University of London

February 1, 1999

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This paper uses a strategic bargaining framework to reassess the effect of dismissal costs in models of voluntary separation. It shows that firing, as opposed to inducing a quit, is always an off-equilibrium strategy for firms in this class of models. Thus, dismissal costs can affect payoffs only if some exogenous event may force the firm to fire the worker despite it being suboptimal, or if the firm's assets are only partly specific to the relationship. In this latter case, dismissal costs increase the specificity of the firm's capital and depress ex post expected profits. In any case, firing restrictions do not affect separation decisions, as firms always find it profitable to induce workers to quit whenever separation is efficient. Involuntary separation is an essential feature of a world in which firing costs result in a lower probability of separation. In such a world, they may be welfare improving, as the separation rate is inefficiently high in the absence of firing restrictions.

J.E.L classification codes: J32, J63, J65

Keywords:Coase theorem, Firing costs, Involuntary separation