Uncertainty, Specificity and Institutions

We show how labour market restrictions, such as firing costs, and bail-outs may arise as useful institutions to support investment in specific human capital. The specificity of human capital is determined endogenously. While specific human capital is more productive than the general human capital, it cannot be reallocated across industries. Accordingly, the optimal fraction of individuals with specific human capital depends on the precision of the signal about future productivity — our measure of uncertainty in the economy. Investment in specific human capital is inefficiently low when firms cannot commit not to fire workers in bad times. Firing restrictions alleviate this commitment problem. However, firing restrictions also impose a cost on firms as they limit their ability to discipline workers and, as a result, reduce the amount of unverifiable effort exerted by workers in equilibrium. Presuming that the benefit from providing the effort does not vary with the type of human capital, we find that economies with relatively little uncertainty will choose to impose firing restrictions, as they derive greater benefit from the investments in specific human capital. Furthermore, when the signals about future productivity are very precise, firms with good signals hire so much specific human capital in the optimal allocation that they are unable to pay their wage bill should they realize a low productivity level. Thus, supporting the optimal allocation requires commitment from financiers or government to bail out these unexpectedly unlucky firms. Hence, such bail-outs may be part of an optimal arrangement, but only when coupled with firing restrictions. ∗We thank Daron Acemoglu, Elhanan Helpman, Torsten Persson, Guido Tabelini, for their encouragement and feedback. We are especially grateful to Césaire Meh for his insights in related joint work. It is worth noting that (supporting) large investments in specific human capital make(s) economy vulnerable to turbulence. As a result, ex-ante appropriate (good) institutions may appear to be bad ex-post as they make economies vulnerable to shocks such as turbulence. As an example, the firing restrictions in Europe and Japan, which appear to be an inefficient institution ex-post, may have been a part of an efficient arrangement ex-ante. Journal of Economic Literature Classification Numbers: J24; J41; J62; D92