This paper constructs a theory of the coexistence of fixed-term and permanent employment contracts in an environment with ex ante identical workers and employers. Workers under fixed-term contracts can be dismissed at no cost while permanent employees enjoy labor protection. In a labor market characterized by search and matching frictions, firms find it optimal to discriminate by offering some workers a fixed-term contract while offering other workers a permanent contract. Match-specific quality between a worker and a firm determines the type of contract offered. We analytically characterize the firms' hiring and firing rules. Using matched employer-employee data from Canada, we estimate the wage equations from the model. The effects of firing costs on wage inequality vary dramatically depending on whether search externalities are taken into account.
JEL classification: H29, J23, J38, E24
Key words: employment protection, unemployment, dual labor markets, wage inequality
The authors gratefully acknowledge comments and suggestions from participants at workshops at the University of Iowa, the Bank of Canada; the 2010 Search and Matching Workshop in Konstanz (especially our discussant, Georg Duernecker); the Midwest Macroeconomics Meetings; the Computing in Economics and Finance Meetings; the Canadian Economics Association Meetings; and especially Shouyong Shi and David Andolfatto. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.
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