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Employment Protection, Product Market Regulation and Firm Selection

Product and labor market regulation differ substantially across OECD countries. Whereas Anglo-Saxon countries have flexible labor markets and deregulated product markets the opposite is the case for continental European countries. However, continental European countries have attempted policy reforms to relax the stringency of their regulations in the past decades.

Thus, it is important to understand the economics of both types of regulation in a unified framework in which product and labor market regulation each play a distinctive role but also interact endogenously by changing the costs and benefits of the respective other policy. In this paper we focus on important policies such as wasteful firing costs3 in labor markets and administrative fixed and set-up costs in product markets. Our model with multiple-worker firms explicitly allows us to distinguish between the exit-and-entry (extensive) margin, and the hiring and-firing (intensive) margin.

We characterize analytically how both margins depend on the policies before we calibrate the model to the US economy. We find that firing costs primarily matter for adjustment at the intensive margin: incumbent firms that are exposed to exogenous changes in business conditions will hoard more or less labor depending on the adjustment costs. Fixed or set-up costs in the product market instead alter primarily the behavior of firms at the extensive entry margin and thus the total number of firms producing in equilibrium.

The model also allows us to highlight important interactions between the policies. Firing costs lower the asset value of the firm and thus encourage exit whereas product market regulation matters for labor hoarding through a selection effect. Higher fixed costs imply higher average firm productivity and a smaller number of firms with larger average size so that aggregate steady-state mobility costs decrease although job turnover per firm increases.

Employment Protection, Product Market Regulation and Firm Selection