Econometrica: Jul 1977, Volume 45, Issue 5
On the Theory of Layoffs and Unemployment
Martin Neil BailyThis paper develops a theory of the firm's demand for labor when workers, at the time they are hired, know that they may later be laid off. The derived behavior shows how the firm, in response to price falls of increasing severity, will first reduce hours of work. After a minimum work week has been reached layoffs start. The point at which this occurs depends upon the income workers expect to receive if they are laid off. Since unemployment insurance (UI) benefits are an important determinant of this income level, they influence the number of layoffs. Given the absence of an effective incentive tax in practice, we would predict that the present UI system encourages layoffs. An effective, incentive tax could stop this encouragement. Two possible wage strategies are explored, both of which are consistent with the basic layoff and hours model. The flexible wage policy has the advantage of giving no incentive to the firm to default on the (privately) efficient layoff rules derived earlier, but seems to be inconsistent with observed short-run wage policy. The fixed wage policy has its strength and weakness the other way around.
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