A Pure Theory of Job Security and Labor Income Risk

Models of labor market equilibrium where forward-looking decisions maximize both proÞts and labor income on a risk-neutral basis offer valuable insights into the effects of employment protection legislation. Since risk-neutral behavior in the labor market presumes perfect insurance, however, job security provisions plays no useful role in such models. This paper studies a stylized model of dynamic labor market interactions where labor reallocation costs are partly Þ-nanced by uninsured workers consumption ßows. In the resulting second-best equilibrium, provisions that shift labor reallocation costs to risk-neutral employ-ers can increase productive efficiency if their administrative deadweight costs are not too large, and increase workers welfare as long as employers Þring costs at least partly Þnance workers mobility. ∗Previous versions of this material offered numerical rather than analytical results, circulated under slightly different titles, and were read as the Review of Economic Studies Lecture at a Royal Economic Society meeting, as an ASSET Lecture, and at several seminars. This version beneÞts from useful comments received on those occasions, at a UCL seminar presentation, from three referees, an Editor, Mirko Wiederholt