A Pure Theory of Job Security and Labor Income Risk

Models of labor market equilibrium that let forward-looking decisions be aimed at maximization of expected pro ̄ts and labor income offer valuable insights into the e®ects of job security provisions, but can hardly explain why they would ever be imposed. This paper's model of dynamic labor market interactions lets labor reallocation costs be partly ̄nanced by risk-averse workers' consumption °ows. In the resulting second-best equilibrium, job security provisions increase workers' welfare and need not reduce productive e±ciency as long as employers' ̄ring costs at least partly ̄nance workers' mobility. ¤Previous versions of this material, which o®ered numerical rather than analytical results, circulated under slightly di®erent titles and were read as the Review of Economic Studies Lecture at the 1997 Royal Economic Society meeting, as the 1997 ASSET Lecture, and in various seminars. Helpful comments are gratefully acknowledged, as are the hospitality of the IMF Research Department, the support of Consiglio Nazionale delle Ricerche, and that of the European University Institute Research Council.