Labor market rigidities and economic efficiency: Evidence from Spain

► We assess the impact of Spanish labor reforms that restricted the use of temporary workers. ► We study the gap between an input's value of marginal product and its price. ► Our results suggest a positive and significant impact of these reforms on the permanent labor gap. a b s t r a c t a r t i c l e i n f o In the 1990s, Spain approved two labor reforms aimed at reducing the unemployment level and its volatility. Overall, these reforms involved two measures designed to induce firms to meet their labor needs via adjustment of permanent positions: restricting the use of temporary workers and reducing the amount of severance payments. This paper empirically assesses the impact of these reforms on the allocative efficiency of the labor input employing Petrin and Sivadasan's (2011) value of the marginal product-marginal cost gap methodology. We find a statistically significant increase in within-firm permanent labor gaps following the reforms. These results suggest that restrictions on the use of temporary workers (increasing the probability of hiring fragile workers for permanent positions), when coupled with uncertainty about enforcement of reduced severance payments, could more than offset the reduction in severance payments; hence, the net effect of the reforms could be to increase adjustment costs for permanent positions. Traditional economic theory suggests that firms adjust employment to equate the marginal revenue product of labor with its marginal cost. In practice however, firms are confronted with several rigidities that may prevent them from adjusting employment to its optimal level. Job security provisions, such as dismissal costs and severance payments, raise the firm's adjustment costs; hence firms might find it optimal not to hire workers when a positive shock pushes the marginal revenue product of labor above its wage (Bertola, 1990; Hopenhayn and Rogerson, 1993). When dismissal costs are high, firms might even choose to retain workers whose wages exceed their marginal product (Blanchard and Portugal, 2001). Moreover, hiring could diminish if job security provisions increased the power of incumbent workers, resulting in higher wages for insiders (Caballero and Hammour, 1997). The effect of employment protection laws (EPLs) on economic performance has sparked a vigorous debate among economists (see Freeman, 2005). Beginning with the seminal work of Lazear (1990), there is a broad and growing literature that explores the consequences of job security provisions on labor market performance and ☆ We are grateful …