The consequences of job security provisions for employment, output, and welfare constitute an issue of great concern for economists and policymakers. Labor market rigidities, particularly those regarding workers’ layoffs, are commonly blamed for the high European unemployment rates (see OECD, 1994a, for an example of this view). Following this belief and hastened by the worsening of unemployment rates during the 1980s, several European countries undertook institutional reforms aimed at deregulating labor markets.
A common feature of these reforms was the elimination of most restrictions on the use of non-causal fixed-term (also called temporary) contracts, which are characterized by much lower firing costs than those of permanent contracts. Since their introduction, fixed-term contracts have accounted for most new hirings in all sectors and occupations (OECD, 1993). Spain, with the highest unemployment rate among the industrialized countries, is a paradigmatic case. After the 1984 reform that allowed the widespread signing of non-causal fixed-term contracts, Spain has become the European country with the highest share of temporary employment: 32 percent in 2000. In addition, temporary contracts accounted for more than 98 percent of hires in the period right after the reform. Dolado et al. (2002) provide an informative survey of the Spanish experience with fixed-term jobs.
Until now, the literature evaluating the aggregate outcome of these institutional reforms has been sparse. While their impact on flows (both job creation and job destruction have increased) and on the variability of employment (also increased) seems clear, the effect of the reforms on unemployment level and welfare is less obvious. Although the existence of firing costs will reduce the level of hirings after a positive shock, firings after a negative shock will also be lower. Even more important, the research on layoff cost has shown how existing quantitative results depend crucially on different modelling choices (see Ljungqvist, 2002, for a thorough discussion).
To fill this gap, this paper quantitatively studies the effects of temporary contracts on quantities and prices. We develop a general equilibrium model with heterogeneous households, heterogeneous firms, and incomplete markets. In our economy, households work, search, and consume subject to a set of allowed labor contracts and a borrowing constraint, while firms maximize profits. The existence of firing costs transforms the firms’ problem into a non-trivial intertemporal one.
We calibrate our model to Spanish data because the rate of temporality created by the reform of 1984 makes Spain a fascinating case study. An interesting point of our calibration is that some of the parameters are estimated with a dynamic partial equilibrium model and longitudinal data of Spanish firms.
The theory measures the consequences of fixed-term contracts for employment, labor turnover, productivity, and welfare. Our main finding is that eliminating temporary contracts reduces unemployment. In our model, unemployment is a function of the flows of job creation/destruction and the intensity of search undertaken by households. Since temporary contracts lower the adjustment costs created by severance payments, the elimination of these contracts decreases the flows into unemployment. Moreover, in the absence of temporary contracts, households search more intensively because the pool of jobs being offered improves. The combination of a higher search intensity and fewer layoffs reduces the equilibrium rate of unemployment. The fall in the matching probability induced by the lower number of vacancies posted is of second order and does not overcome the first two forces. Our result suggests that as a recipe to fight high unemployment rates, temporary contracts are a failure.
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Evaluating Labor Market Reforms: A General Equilibrium Approach
