On the Welfare Implications of Firing Costs

This paper derives a model in which workers have firm-specific and industry-specific skills, and in each period there is a non-zero probability that a worker quits. The quitting probability makes the private discount rate (used by firms in making decisions about firing workers) higher than the social discount rate. This generates a “quitting externality”, where firms lay off too many workers in a recession. Firms are too quick to dispose of their human capital in a cyclical downturn because it is of less value to them than it is to society. This may provide a rationale for state-mandated redundancy payments as a second-best remedy to overcome the market failure.