SEMINAR 21 January 2013: Etienne Lalé, Sciences-Po, Paris

Matching Frictions, Self-Insurance and Severance Payments

Abstract

This paper develops a quantitative model to study the employment and welfare implications of government-mandated severance payments. Key elements of the analysis are matching frictions, imperfect insurance markets faced by risk-averse workers and potential wage-shifting effects of severancep ayments. In the proposed setting, workers’ preferences and ability to carry wealth across periods allow transfers from the employer to the dismissed employee to be non-neutral, while bargaining at the worker-firm level implies that such transfers may be fully internalized in wages. Thus, unlike existing studies, the analysis does not need to take an a priori stand on the neutrality of severance payments. The model calibrated on U.S. data reveals a hump-shaped effect of this policy on workers’ welfare, peaking for severance payments around six months’ wages. Moderate levels of severance payments are effective in insuring workers against labor market risk and have little effect on job creation since employers cushion the expected payments by reducing the wages of newly-hired workers. Higher levels of severance payments cannot be as easily offset through cuts in wages at the entry level. This eventually leads firms to reduce vacancy creation, the duration of unemployment to increase and welfare to deteriorate.

Keywords: Severance Payments, Search and Matching, Incomplete Markets, Welfare Effect

JEL codes: E21, D52, J63, J65