This Selected Issues paper analyzes the recent French inflation behavior. The paper demonstrates that the recent change in French headline inflation behavior resulted from a few idiosyncratic, i.e., transient, factors. The paper describes the model setup and calibration of some crucial economic relations and parameters. The level of competition in labor and product markets in France and the other EU countries is discussed, including the size of markups. The paper also looks into the economic impact of increasing competition in each market separately and the advantages of coordinating reforms within the euro area.

Abstract

This Selected Issues paper analyzes the recent French inflation behavior. The paper demonstrates that the recent change in French headline inflation behavior resulted from a few idiosyncratic, i.e., transient, factors. The paper describes the model setup and calibration of some crucial economic relations and parameters. The level of competition in labor and product markets in France and the other EU countries is discussed, including the size of markups. The paper also looks into the economic impact of increasing competition in each market separately and the advantages of coordinating reforms within the euro area.

III. Employment Protection and Unemployment in France38

A. Introduction

56. Unemployment has remained high in France for the last two decades, despite some improvements during the late 1990s. In particular, the unemployment rate has risen since 2001, though mostly for cyclical reasons to about 10 percent recently. This has prompted the government to adopt an emergency plan for employment (le plan d’urgence pour l’emploi) and set the reduction of unemployment as the top government priority.

57. In the past, policies to address high structural unemployment have focused mainly on active labor market programs, leaving labor market rigidities largely untackled. Remedial actions relied on employment subsidies, earned income tax credits, and cuts in social security contributions—all at a considerable cost to the budget. Attempts were made to reduce unemployment through work redistribution efforts, such as the reduction in the workweek. Despite these efforts, the French unemployment rate remains higher than the euro area average. Meanwhile, the tax wedge on labor remains high, permissible work hours are constrained, employment protection is strict, and minimum wage policy prices workers with low productivity out of employment (Figure 1).

Figure 1.
Figure 1.

Labor Market Performance and Institutions, France and Selected Countries

Citation: IMF Staff Country Reports 2005, 397; 10.5089/9781451813654.002.A003

Sources: OECD; and IMF staff calculations.

58. Recent studies suggest that reform of employment protection legislation is needed to enhance job creation. A number of recent reports, some sponsored by the government, offer various reform proposals. The de Virville report (2004) suggests relaxing legal restrictions on the use of fixed-term contracts. Cahuc and Kramarz (2004) recommend the merger of permanent and fixed-term contracts into a single contract, with severance pay based on the duration of employment. Similarly, Blanchard and Tirole (2003) and Cahuc and Malherbet (2002) propose reducing firing costs associated with legal and administrative procedures and introducing a system of experience-rating into the unemployment benefit system. Most recently, the OECD country report (2005) also recommends reducing the difference between permanent and fixed-term contracts either by introducing a single contract with lower employment protection, or by reducing the legal and administrative costs of termination of permanent contracts and easing the use of fixed-duration contracts.

59. In August, a new employment contract, le contrat nouvelles embauches or CNE, became effective. The CNE is a special employment contract with a trail period of up to two years. Termination of such a contract during the trial period is not subject to the administrative and legal procedures that apply to permanent open-end contracts (contrats à durée indéterminée, or CDI), and severance pay is based on the duration of employment. At the end of the two-year trial period, a CNE would have to be converted to a CDI if not terminated. With no firing restrictions, a CNE contract compares favorably to a regular CDI contract. With a duration-based severance pay and no hiring restrictions, it also compares favorably to a fixed-duration contract (contrat à durée déterminée, or CDD) (See Section B). However, the use of CNE contracts is restricted to small enterprises with less than 20 employees.

60. This paper analyzes the unemployment effects of reform proposals offered by recent reports, with a view to assessing the effectiveness of the CNE in promoting job creation and reducing the structural unemployment rate. It uses a search-matching model with hiring and firing restrictions to identify the channels through which changes in employment protection legislation (EPL) affect hiring and firing decisions and aggregate labor market variables such as unemployment. This approach recognizes the frictions and imperfect information that exist in labor markets. With its focus on the job creation and destruction decisions of the firm as well as the job search behavior of the worker, it provides a useful framework for studying impacts of labor market policies (Pissarides and Mortensen, 1999).

61. The structure of the paper is as follows: Section B summarizes the key characteristics of the French employment legislation. Section C briefly reviews the theoretical and empirical literature on the labor market impact of arduous employment protection legislation, with a focus on studies related to France. The analytical framework is discussed in Section D (and the detailed model in Appendix I). Section E presents the simulation results from the calibrated model. Section F concludes with policy implications.

B. Employment Protection Legislation (EPL) in France

62. Employment protection for workers hired under permanent contracts is very strict. These workers are protected against unemployment resulting from company restructuring, under the current law on layoffs for economic reasons (licenciement économique). Although severance pay does not appear to be particularly high compared with other European countries and the notice period (one or two months depending on seniority) is relatively short,39 a dismissal for economic reasons can be costly, as it is subject to complex and long administrative procedures and various legal restrictions.40 In particular, justifications for dismissals of permanent workers due to economic reasons are strictly defined. Economic dismissals are allowed for preserving firms’ competitiveness, but not for improving firms’ competitiveness or profitability. The economic burden on firms is further increased by their legal obligation to find new jobs for the redundant workers.

63. Collective dismissals for economic reasons are subject to even more complex administrative procedures. In case of a collective dismissal, firms have to negotiate with the joint production committee. If the collective dismissal involves more than ten workers, an “employment preservation plan” (plan de sauvegarde de l’emploi) is required, which sets out measures for helping outside-firm job search, creating new activities, and improving training programs. Large firms (with more than 1,000 workers) also have to offer “reclassification leave,” which is about four to nine months. During this leave period, firms are required to provide the redundant workers with training and assistance to find a job.

64. Workers hired on fixed-duration contracts (CDDs) do not have the same employment protection, but the use of these contracts is rather restricted.41 The layoff of workers with CDDs involves a severance payment and a notice period but does not require a costly administrative and legal process. However, CDDs can only be used for temporary increases in production activities or for replacing employees on leave, and cannot be used to fill permanent positions linked to permanent production activities. CDDs can be renewed only once, with the maximum duration usually limited to 18 months (including renewal).42 At the end of a CDD, the worker will either be hired on a regular CDI or receive a severance payment equivalent of 6 percent of the total salary received during the employment period. In the case of early termination of a CDD, the firm has to pay for the entire period specified by the contract. Consequently, although the maximum duration allowed is 18 months, the average effective duration of CDDs is relatively short (less than 3 months), compared to other European countries (about 6-12 months) (Figure 2). Furthermore, when a CDD is terminated for economic reasons, the firm is not allowed to hire another worker under a CDD for six months.

Figure 2.
Figure 2.

France: Average Duration of Temporary Contracts by Sector

(In months)

Citation: IMF Staff Country Reports 2005, 397; 10.5089/9781451813654.002.A003

Source: OECD (2005).

65. Overall employment protection in France has increased since the late 1980s, due both to new legislation and to jurisprudence (Figure 1). Specifically, the employment protection legislation (EPL) concerning permanent labor contracts has been strengthened, as procedures for economic dismissal have become more complex, legal restrictions on economic dismissals have been tightened, and the burden on firms to help redundant workers to find new jobs has increased (OECD, 2005).

66. With stricter EPL for permanent contracts, the use of fixed-duration contracts has risen, leading to growing labor market segmentation and unequal treatment between workers. The share of workers hired with CDDs in total dependent employment has risen to 15 percent from less than 5 percent in the mid-1980s, accounting for about 80 percent of the new hires (Cahuc and Postel-Vinay, 2001). Therefore, while a majority of workers benefit from high employment protection, a growing number of them—mainly young workers—find themselves alternating between unemployment and short fixed-duration contracts, with increasing difficulty of obtaining a permanent or high productivity job.43 Indeed, the recent increase in the unemployment rate has fallen disproportionally on the young and the low-skilled, who are most likely hired with CDDs (Figure 3 and Text Table).

Figure 3.
Figure 3.

France: Unemployment Rate and Duration by Age Group

Citation: IMF Staff Country Reports 2005, 397; 10.5089/9781451813654.002.A003

Source: OECD.

Unemployment Rate in France, 2002-04 1/

article image
Source: Insee, Enquêtes sur l’emploi.

Annual average, ILO definition.

C. Literature Review

67. The impact of EPL on employment and unemployment has been the subject of a vast literature. It is generally accepted that an arduous EPL inhibits labor market flexibility by reducing firms’ ability to adjust the work force during changing economic conditions. However, the effects of firing and hiring regulations on unemployment have long been debated among economists and policymakers. In theory, arduous EPL leads to a low separation rate but long unemployment duration, with an ambiguous effect on the overall unemployment rate. Firing restrictions are often justified by the need to protect workers from arbitrary actions of firms and to provide some stability in employment (Blanchard and Tirole, 2003). Some even argue that firing and hiring restrictions may promote long-lasting relationships between workers and the firm and encourage investment in human capital. Others assert that strict EPLs can have negative effects on job creation, because they weaken firms’ ability to take advantage of the opportunities offered by new technologies and access to new markets that often require a change in the skill composition of the workforce (Pierre and Scarpetta, 2005). Moreover, there is growing evidence that such EPLs may reduce certain groups’ access to jobs, including women, the young, and the low-skilled.

68. There is a consensus, however, that the effects of EPL are contingent on the initial characteristics of the labor market. Simulations of calibrated models for a typical European labor market find that the effect of a strict EPL on job destruction is stronger than its effect on job creation, resulting in higher unemployment (Blanchard and Landier, 2001; and Cahuc and Postel-Vinay, 2001). Strict EPLs were introduced in many EU countries in the 1970s when unemployment was low, hence the impact was limited. When labor market conditions changed in the 1980s and 1990s, the dynamic between economic shocks and EPL changed, too. Blanchard and Wolfers (2000) suggest that EPL accounts for part of the increase in unemployment and unemployment persistence in a sclerotic labor market characterized by high unemployment. An empirical study by Elmeskov and others (1998) find a robust positive effect of EPL on unemployment in the OECD countries.

69. One branch of the literature concerns the impact of targeted EPL on labor market performance. In France as well as in many other European countries, employment protection was reduced significantly for workers hired under fixed-term contracts—who constitute the majority of the newly-employed—but maintained for those hired under permanent contracts. Some contend that this type of partial reform may enable a gradual build-up of support for reform and serve as the intermediate step towards a complete reform. The argument is that, from the political economy point of view, persistent high unemployment could also be the result of the lack of political support for reforms to reduce unemployment, since political decisions are likely to reflect the interests of the employed majority rather than the unemployed minority (Saint-Paul, 1993).

70. Many studies find this type of partial reform an ineffective way to reduce unemployment, with negative implications for workers’ welfare and productivity.44 Cahuc and Postel-Vinay (2001) conclude that achieving labor market flexibility through promoting temporary jobs without a parallel reduction of high firing costs for permanent workers is both ineffective in fighting unemployment and inefficient in improving aggregate welfare. Similarly, Blanchard and Landier (2001) argue that the effects of such partial reform of employment protection may be perverse, with the main effect being a high turnover in fixed-duration workers, leading in turn to higher unemployment. Looking at French data for young workers since the early 1980s, they conclude that the reforms have substantially increased turnover, without a substantial reduction in unemployment duration, but with negative welfare implication for the young workers. Evidence from other countries, including Spain and Sweden, also suggests that under the system of targeted EPL, firms have strong incentives to hire workers at the entry level, on short fixed-duration contracts and without providing them a permanent job at the end of the contract. This increases job turnover but not necessarily overall employment or productivity. In Spain, net job creation began to rise, and unemployment began to fall significantly only after the government reformed the EPL for permanent contracts in the mid-1990s (Box 1).

Reforming Employment Protection Legislation: the Experiences of Spain and Sweden1

Spain. Before 1984, Spain had one of the most rigid EPLs in Europe. When the unemployment rate reached 20.1 percent in 1984, the Spanish EPL was reformed by easing the use of fixed-term contracts for nonseasonal productive activities while keeping the rigid EPL for permanent contracts. The use of fixed-term contracts was extended to hire workers performing regular activities, and the dismissal costs for these contracts were reduced substantially. Subsequently, the proportion of fixed-term workers in total dependent employment surged, exceeding 30 percent in 1993, as firms used fixed-term contracts for regular jobs. The unemployment rate, after falling initially, began to rise again in 1990, exceeding 24 percent in mid-1994. Dolado and others (2002) suggest that the expansion of short fixed-term jobs to increase labor market flexibility may be undesirable, especially when there is a strong EPL for permanent jobs. It may lead to unexpected perverse effects stemming from the existence of a segmented labor market, such as lower in-job training, lower labor productivity growth, and a more unequal distribution of unemployment.

The reforms of 1994, 1997, and 2001 led to the reimposition of some restrictions on the use of fixed-term contracts, but at the same time the creation of a new permanent contact with lower firing costs. The government also introduced significant rebates of social security contributions for workers under the new permanent contracts. Between 1994 and 2001, the unemployment rate fell by nearly 10 percentage points. Most recently, a new law was introduced in 2002 that provides the possibility of side-stepping the protracted dismissal process, entailing an effective reduction in dismissal costs.

Sweden. In the early 1990s, Sweden experienced a macroeconomic downturn unparalleled in the postwar period. The unemployment rate rose from less than 2 percent in 1990 to more than 8 percent in 1993. In 1994, a reform of EPL was introduced, which was repealed a year later, raising the duration of fixed-term contracts. The subsequent reform in 1997 significantly relaxed the use of fixed-term contacts but kept the restrictive EPL for permanent contracts untouched.2 Employment in fixed-term contacts increased substantially over most of the 1990s, reaching 16 percent of total dependent employment by 2000. Among the other Nordic countries, only Finland has exhibited a similar growth in fixed-term contracts.3

Holmlund and Storrie (2002) find that the partial reform of EPL significantly increased the inflows into unemployment. The annual inflows rose from 5 percent of the labor force at the end of the 1980s to 11 percent in 1990-2000. About 50 percent of the rise in inflows was accounted for by higher inflow from fixed-term jobs. To the extent that there was a trend rise in fixed-term employment during the entire business cycle, it is conceivable that this contributed to an increase in the equilibrium unemployment rate through higher worker separation rates. The Swedish evidence also indicates that there is a wage penalty (about 10 percent) associated with fixed-term workers.

1 Based on Dolado, Garciá-Serrano, and Jimeno (2002) and Holmlund and Storrie (2002).2 According to the OECD, Swedish EPL is fairly restrictive, although it does not stand out as extreme by European standards.3 The Finnish experience was more dramatic than the Swedish one, with both greater increase in fixedterm contracts and in unemployment.

D. Analytical Framework

71. The model used here is based on Dolado and others (2005), which extends the standard Mortensen and Pissarides (1994) matching and search model with firing and hiring restrictions. Unlike the traditional models of aggregate labor supply and labor demand, search models recognize job market frictions and the need to reallocate workers across productive activities in the face of economic shocks. They explicitly model uncertainties associated with future shocks, expectations of firms and workers, and wage determination mechanisms. In this model, decisions taken by firms and workers are mutually consistent. This type of model is often used to study the influence of alternative labor market institutions and policies on wages and unemployment, particularly the impact of employment protection legislations on unemployment in European countries.45 The detailed model is presented in Appendix I.

72. To best capture the main characteristics of the employment protection legislation in France, our model introduces the following assumptions: (i) firms can fill a position by hiring a worker from the pool of unemployed either under a permanent CDI contract (i=1) or a fixed-duration CDD contract (i=2); (ii) the termination of a CDI is costly, with firing cost K1, which is treated as pure waste and not as a transfer to workers; and (iii) CDDs can be terminated at a lower cost K2, but the use of CDDs is restricted by government regulations.46

73. Job vacancies and unemployed workers meet according to a matching function m(v,u), where v and u represent, respectively, the number of vacant jobs and of unemployed workers. The matching function captures the job-searching behavior of the unemployed. The rate at which vacant jobs are filled is given by q(θ)=m(v,u)/v, where θ = v/u can be interpreted as a measure of the tightness of the labor market from firms’ perspective: firms fill their vacancies easily when there are more workers relative to available jobs. The rate at which an unemployed worker meets a firm with a vacancy is m(u,v)/u. Once the worker and the firm meet, a job is drawn from a distribution function F(ε), and the possibility that this job is offered with a fixed-duration contract is α, which is a policy variable. After a match is formed, wages are determined by a Nash-bargaining solution.

74. A typical risk-neutral worker accepts a job when the value of the employment (W) exceeds and the value of unemployment (U). Specifically, the worker earns w(ε) when employed and producing at productivity ε and searches for a job when unemployed while receiving a real income of b, which could include unemployment insurance benefits and the imputed real return from unpaid leisure activities, such as home production or recreation.

75. A firm decides to fill a vacancy (hire a worker) when the value of a filled-vacancy (V) exceeds the value of when it is unfilled (J). Hiring starts when the value of a filled vacancy is higher than the value of an unfilled vacancy, with the hiring threshold determined by equating the two values. A job is terminated when its value falls below the value when vacant minus firing cost, which determines the firing threshold. In steady-state, free entry drives the value of an unfilled vacancy to zero.

76. Job creation and job destruction are endogenously determined.47 Each job is characterized by a fixed technology and produces a unit of a differentiated product. A job is created when a firm and a searching worker meet, agree to a match at a negotiated wage, and start producing.48 Once a job is created, production continues until a negative idiosyncratic productivity shock arrives, at which point the productivity of the job moves to the low value. Jobs of which the productivity falls below a productivity threshold (the reservation productivity) are destroyed, and jobs with productivity above it are continued. When a job is terminated, the firm must pay a pure-waste firing cost. When the firm and the worker separate, the worker moves from employment to unemployment, and the firm can either withdraw from the market or open a new job vacancy. Equilibrium unemployment is obtained when the flow into unemployment equals the flow out of it.49

77. The job-creation curve (JC) and the job destruction curve (JD) capture the relationships between the productivity thresholds for hiring or firing and the labor market tightness (Figure 4). It can be shown that as the labor market tightness increases, workers have a higher reservation value and, therefore, the firing productivity threshold increases. Hence, the job-destruction curve is upward sloped. The job-creation condition is determined by the free-entry condition: job creation stops when there is no rent left for the firm. The JC curve slopes downward.

Figure 4.
Figure 4.

Model Diagram

Citation: IMF Staff Country Reports 2005, 397; 10.5089/9781451813654.002.A003

78. In the steady state, a system of six equations solves for six variables: hiring and firing thresholds for workers with different types of contract (ɛij, i=1,2 and j=d,h), labor market tightness (θ), equilibrium unemployment (u*), and the composition of unemployed (δ). The system is recursive, in the sense that the productivity thresholds for hiring and firing each type of worker depend on labor market tightness, which, in turn, is determined by the job flows implied by these hiring and firing thresholds.

79. Reducing firing costs increases job destruction as well as job creation, with an ambiguous effect on steady-state unemployment (Figure 5):

  • For given labor market tightness θ, reducing firing costs raises the firing threshold and lowers the hiring threshold. This increases the expected employment duration of a match (as the inaction area is increased, i.e., the firm fires and hires less frequently), and hence the expected surplus (rent) from filled vacancies rises. Thus, reducing firing costs results in more job destruction as well as more job creation (the JD curve shifts to the left, and the JH curve shifts to the right), with ambiguous effect on unemployment. These results are consistent with the findings of the literature.

  • The effect of lower firing costs on θ depends on the difference between the expected surplus from hiring workers with CDD and the surplus from hiring with CDI. As shown in Dolado and others (2005), it is plausible that the latter is larger than the former. As a result, the share of workers with CDD in total unemployment would go up, and market tightness decreases. The final impact on unemployment would depend on the changes in unemployment for two types of workers, or the change in the unemployment duration.

Figure 5.
Figure 5.

Reduction in Firing Costs K1

Citation: IMF Staff Country Reports 2005, 397; 10.5089/9781451813654.002.A003

80. Facilitating the use of fixed-duration contracts encourages job creation, but at the same time it increases job destruction. Easing restrictions on CDDs raises productivity thresholds for both contracts and overall job market tightness. Since a CDD job (with lower firing costs) yields a higher surplus than a CDI job, increasing the CDD contracts fosters job creation. On the other hand, a tight labor market implies that workers would raise the minimum acceptable productivity of their jobs, leading to increasing wage pressure, which in turn leads to job destruction. The overall effect on unemployment depends, once again, on the relative strength of the job creation and job destruction effects (Figure 6).

Figure 6.
Figure 6.

Increase in the Permitted Share of Fixed-term Contracts

Citation: IMF Staff Country Reports 2005, 397; 10.5089/9781451813654.002.A003

81. In the next section, the model will be calibrated for France to evaluate the relative strength of these counteractive effects.

E. Simulation Results

82. In this section, the model discussed earlier is calibrated for the French labor market and used to simulate the effects of various reform proposals, including (1) the impact of lower firing restrictions on GDIs (Scenario 1, captured by lowering K1); (2) the impact of a less restrictive use of CDDs (Scenario 2, captured by higher α, in line with the reform proposal in the de Virville report); and (3) the impact of a specific combination of lower firing restrictions on CDIs and a merger of CDI and CDD (Scenario 3: lower K1 and lower α, in line with reforms proposed by Kramarz and Cahuc and Blanchard).

83. Parameters for simulations are chosen from existing studies (Table 3). Following Dolado and others (2005), we assume that the productivity of workers with CDDs is uniformly distributed in [0,1] and that productivity of workers with CDIs is uniformly distributed in [1/3, 1]. The utility of being unemployed (a proxy for unemployment benefits) is b=0.25, which represents half of a worker’s average productivity. The cost of holding a vacancy unfilled is set at c=1/3. The matching function m(u,v)=MuηvI-η is assumed to be Cobb-Douglas, in line with recent studies on France (for example, Cahuc and Postel-Vinay, 2001). The base period is one quarter, and the quarterly interest rate is set at 0.01. The arrival rate of productivity shocks is set at λ =0.081, as in Mortensen and Pissarides (1994). The policy variables are captured by firing costs K1 and K2 and by hiring restriction α. The base case with an unemployment rate of about 10 percent is calibrated by choosing K2 while setting K1=1 and α =0.2.

Table 3.

Baseline Parameters

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84. The results of the simulation are summarized in Table 4. They indicate that lowering firing costs for CDIs by 50 percent would lower the unemployment rate by 1 percentage point. The results also confirm the main conclusions in Blanchard and Landier (2001) and Cahuc and Postel-Vinay (2001): a partial EPL reform that relaxes the use of CDDs while keeping EPL for CDIs unchanged would lead to a higher, not lower, unemployment rate. A reform along the line of the proposal by Kramarz and Cahuc, which lowers the firing cost of CDIs to that of CDDs, thus effectively merging both contacts, would lower the unemployment rate by 2 percentage points. This effect would be even larger (about 3 percentage points) when firing restrictions are eliminated (Scenario 4).

Table 4.

Simulated Effects of Various EPL Reform Proposals

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Source: IMF staff estimates.

85. These results are subject to some caveats. First, they depend on the specifications of the matching function as well as the distribution function of productivity. For example, simulations using a CES matching function as specified in Dolado and others (2004) imply a much larger negative unemployment effect of a partial EPL reform (raising the unemployment by 2.5 percent instead of 1 percent when using a Cobb-Douglas matching function). Second, our model does not capture one key element of the French wage setting mechanism, namely the existence of minimum wages.50 As shown in Cahuc and Zylberberg (1999), the impact of job protection policies on unemployment is strongly influenced by the wage setting mechanisms. High and binding minimum wages prevent the internalization of high hiring costs (which is a key assumption of our model). Since high minimum wages may already price the low-skilled workers and young workers out of jobs, together with strict EPL, they can significantly lower the chances of these workers of coming to the active labor force.

F. Concluding Remarks

86. The new employment contract takes an important step toward reforming the employment protection legislation in France, but its effectiveness depends on further reforms. While it will facilitate hiring, the CNE represents only a partial reform of the employment protection legislation. It introduces the needed flexibility for only up to two years and is limited to small enterprises. Moreover, it is equivalent to a fixed-duration contract with no hiring and firing restrictions. Easing the restriction on fix-duration contracts while keeping the strict firing restrictions on permanent contracts could undermine the effectiveness of the reform, as evidenced by the experiences from other countries, such as Spain and Sweden.

87. The effectiveness of the new labor contract in promoting job creation and reducing the unemployment rate will depend crucially on broadening its application and adopting supporting reforms. Simulations of a search-matching model, with hiring and firing restrictions calibrated to the French labor market, suggest that a reform, which effectively merges existing contracts into a single one by lowering firing costs and legal uncertainty (e.g., as in the proposal by Kramarz and Cahuc), would lower the structural unemployment rate by 2 percentage points. This effect could be even larger (about 3 percentage points) when firing restrictions are completely eliminated. The magnitude of these estimates should be interpreted with caution. It is sensitive to the choice of parameters and assumes efficient employment services and minimum wages that are sufficiently low to allow internalization of hiring and firing costs.

APPENDIX I The Model

1. The model used here is based on Dolado and others (2005) and extends the standard Mortensen and Pissarides matching and search model (1994) with firing and hiring restrictions. In this model, the equilibrium unemployment rate is determined by both flows into unemployment and unemployment duration. This type of models is often used to study the effects of labor market policies, particularly employment protection legislations, on unemployment in European countries.51

2. To best capture the main characteristics of the employment protection legislations in France, the model introduces the following assumptions: (i) firms can fill a position by hiring a worker from the pool of unemployed either under a permanent CDI contract (i=1) or a fixed-duration CDD contract (i=2); (ii) the termination of a CDI is costly, with firing cost K1; which is treated as pure waste and not as a transfer to workers; and (iii) CDDs can be terminated at a lower cost K2, but the use of CDDs is restricted by government regulations.52

3. Job creation and job destruction are endogenously determined.53 Each job is characterized by a fixed technology and produces a unit of a differentiated product. Each firm has one job to offer, thus the number of firms is the same as the number of jobs. The cost of keeping a job vacancy unfilled is c. A job is created when a firm and a searching worker meet, agree to a match at a negotiated wage, and start producing.54 Once a job is created, production continues until a negative idiosyncratic productivity shock arrives, at which point the productivity of the job moves to the low value. Jobs with productivity falls below a productivity threshold (the reservation productivity) are destroyed, and jobs with productivity above it are continued. When a job is terminated, the firm must pay a pure-waste firing cost. When the firm and the worker separate, the worker moves from employment to unemployment, and the firm can either withdraw from the market or open a new job vacancy.

4. The model considers an economy populated by a fixed labor force (normalized to one). Workers are risk-neutral, infinitely-lived, and can either be employed and producing or unemployed and searching. For simplicity, there is no on-the-job searching.55

Matching process

5. Job vacancies and unemployed workers meet according to a matching function m(v,u), where v and u represent, respectively, the number of vacant jobs and of unemployed workers. The matching function is increasing in both arguments and assumed to be concave, with constant returns to scale. Moreover, m(v,0)=m(0,u)=0.

6. The rate at which vacant jobs are filled is given by

q(θ)=m(v,u)/v=m(1,u/v)=m(1,1θ),q(θ)0.

where θ = v/u can be interpreted as a measure of the tightness of the labor market from the firm’s perspective: the fewer unemployed the harder for the firm to fill a vacancy. During a small time interval dt, a vacant job is matched to an unemployed worker with probability q(θ)dt, so that the average duration of a vacant job is 1/q(θ). The probability that a vacant job will not be filled is 1- q(θ)dt.

7. The rate at which an unemployed worker meets a firm with a vacancy is given by

m(v,u)/u=θq(θ)

8. Once the worker and the firm meet, a job is drawn from the distribution F(ε), and the possibility that this job is offered with a fixed-duration contract CDD is α. The probability that an unemployed worker will not find a job is 1- θq(θ)dt, with an unemployment duration of 1/ θq(θ). It is easy to see that:

d(1/q(θ))/dθ0
d(1/θq(θ))/dθ0

Thus unemployed workers find jobs easily when there are more jobs relative to the available workers, and the firms fill their vacancies easily when there are more workers relative to the available jobs.

9. In this model, the flow into unemployment results from idiosyncratic productivity shocks that arrive to occupied jobs (a CDI job or a CDD job) at the Poisson rate λ. Equilibrium unemployment is obtained when the flow into unemployment equals the flow out of it.56 The flow into unemployment is the fraction of jobs that gets hit by a productivity shock below the productivity threshold εid (i=1,2), with the probability Fiid).

Therefore, the flow into unemployment (job destruction) is given by λF11d)(1-α)(1-u) for a CDI worker and λF22d)α(1-u) for a CDD worker, with labor force normalized to be unity.

10. Hence, for given matching probabilities and productivity thresholds, the steady-state flow equations are given by:

[(1F1(ε1h)]θq(θ)(1δ)u=λF1(ε1d)(1α)(1u).(1)[(1F2(ε2h)]θq(θ)δu=λF2(ε2d)α(1u).(2)

where δ is the share of unemployed CDD workers in total unemployment.

11. The steady-state unemployment can be solved as:

u*=λF2(ɛ2d)[1F2(ɛ2h)][(1δ)/(1α)]θq(θ)+λF2(ɛ2d)(3)

Equation 3 implies that for a given arrival rate of productivity shocks (λ) and labor market tightness (θ), there is a unique equilibrium unemployment rate.

Firms

12. For the firms, the value of an unfilled vacancy (V) and the value of filled vacancies of productivity ε with contract type i are given by the following equations:

rV=c+(1δ)q(θ)ɛ1h1[J1(x)V]dF1(x)+δq(θ)ɛ2h1[J2(x)V]dF2(x)(4)rJi(ε)=εwi(ε)+λFi(εid)[VJi(ε)Ki]+λεid1[Ji(x)Ji(ε)]dFi(x),(i=1,2).(5,6)

13. A firm decides to fill a vacancy (hire a worker) when its value when filled equals or exceeds the value of when it is unfilled. The hiring threshold is determined when the two values are equal. A job is terminated (a worker leaves employment and enters unemployment) when its value falls below the value of when it is unfilled minus firing costs. This gives the firing threshold.

Workers

14. A typical risk-neutral worker earns w(ε) when employed and producing at productivity ε, and searches for a job when unemployed while receiving a real income of b (which could include unemployment insurance benefits and the imputed real return from unpaid leisure activities, such as home production or recreation). Unemployment income is assumed to be the same for all workers, and firms cannot discriminate against workers hired under fixed-term contracts, as required by the French labor law. Thus, workers with the same productivity are paid at the same wage rate.57

15. For the workers with productivity ε under contract type i, the value of employment (Wi) and the value of unemployment (Ui) are given by the following Bellman equations:

rUi=b+θq(θ)εih1[Wi(x)Ui]dFi(x),(i=1,2)(7)rWi(ε)=wi(ε)+λFi(εid)[UiWi(ε)]+λεid1[Wi(x)Wi(ε)]dFi(x),(i=1,2)(8,9)

Wage determination

16. After a match is formed, wages are determined by a bargaining solution maximizing the weighted product of the worker’s and the firm’s surplus from a job match:58

Max[wi(ɛ)U]β[Ji(ɛ)V+Ki]1β,

where 0≤β≤1 can be interpreted as a relative measure of labor’s bargaining power. Jobs with higher productivities offer high wages. An employment contract between the firm and the worker is a wage w for each period of time that they are together and a separation rule that is contingent on the arrival of an idiosyncratic productivity shock. This contract is renegotiated whenever new information arrives. A symmetric Nash bargaining solution (β=0.5), where the total surplus/rent generated by a job match is equally shared by the worker and the firm, implies:59

Wi(ɛ)U=Ji(ɛ)V+Ki(10)

Equilibrium

17. Hiring stops when the value of a filled vacancy falls below the value of an unfilled vacancy, and a job is terminated when the value of the job is below its value when vacant minus firing cost. In steady-state, the free entry drives the value of an unfilled vacancy to zero, hence we have:

Ji(εih)=VJi(εid)+Ki=VV=0

18. The first two equations above determine the productivity thresholds for hiring and firing, which give the job destruction conditions:

εid=bλr+λεid1[1Fi(x)]dx+θq(θ)2(r+λ)εih1[1Fi(x)]dx+{θq(θ)[1Fi(εih)]r}Ki(11,12)εih=bλr+λεid1[1Fi(x)]dx+θq(θ)2(r+λ)εih1[1Fi(x)]dx+{θq(θ)[1Fi(εih)]+r+2λ}Ki(13,14)

Or

(ɛih)(ɛid)=2(r+λ)Ki.(15,16)

Equations 11 and 12 give the relationship between the firing thresholds and the labor market tightness (the JD curve), while equations 13 and 14 give the relationship between the hiring thresholds and the tightness (the JH curve). As shown in Dolado and others (2005), as labor market tightness increases, workers have a higher reservation value and, therefore, the firing productivity thresholds increase. With a higher firing threshold, the initial hiring threshold also increases. Hence, both the JD and JH curves are upward-sloped (see Figure 4).

19. The job creation condition is determined by V=0 (i.e., the free-entry condition, job creation stops when there is no rent left for firms), which can be written as follows:

cθq(θ)=δ2(r+λ)ɛ2h1[1F2(x)dx+1δ2(r+λ)]ɛ1h1[1F1(x)]dx(17)

This equation captures the relationship among tightness, the hiring threshold, and the (composition of) unemployment.

20. In steady-state, a system of six equations (3, 11, 12, 13, 14, 17) solves for six variables: hiring and firing thresholds for workers with different type of contract (ɛij, i=1,2 and j=d,h), labor market tightness (θ), and the equilibrium unemployment (u*). The system is recursive, in the sense that the productivity thresholds for hiring and firing each type of worker depend on labor market tightness, which, in turn, is determined by the job flows implied by these hiring and firing thresholds (see Figure 4).

21. For given labor market tightness θ, reducing firing costs raises the firing threshold and lowers the hiring threshold. This increases the expected employment duration of a match (as the inaction area is increased, i.e., the firm makes less frequent firing and hiring), and hence the expected surplus (rent) from filled vacancies rises. Thus, reducing firing costs results in more job destruction as well as more job creation (JD curve shifts to the left and JH curve shifts to the right), with ambiguous effect on unemployment. These results are consistent with the findings of the literature.

22. The effect of lower firing costs on θ depends on the difference between the expected surplus from hiring workers with CDDs and the surplus from hiring with CDIs. As shown in Dolado and others (2005), it is plausible that the latter is larger than the former. As a result, the share of workers with CDDs in total unemployment would go up, and market tightness decreases. The final impact on unemployment would depend on the changes in unemployment for two types of workers, or the change in the unemployment composition.

23. Facilitating the use of fixed-term contracts, by increasing their rate of approval (α), increases productivity thresholds for both contracts and overall job market tightness. Since a CDD job (with lower firing costs) yields a higher surplus than a CDI job, increasing the CDD contracts fosters job creation. On the other hand, tight labor market implies that workers would raise the minimum acceptable productivity of their jobs, leading to increasing wage pressure, which in turn leads to job destruction. The overall effect on unemployment depends, once again, on the relative strength of the job creation and job destruction effects.

APPENDIX II Variable List

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References

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38

Prepared by Jianping Zhou.

39

For example, for an employee with five years of seniority, severance pay is half of the monthly gross salary per year in the case of a dismissal for “personal” reasons and one month of salary in the case of a dismissal for “economic” reasons (OECD, 2005).

40

Kramarz and Michaud (2004) estimate that for dismissals due to personal reasons, the average firing cost involving a worker with CDD is equivalent to 14 months’ wages and significantly higher in case of a collective dismissal. This suggests that dismissals due to economic reasons can be more costly, since in the case of a dismissal for personal reasons, the firm and the worker often reach an agreement with high severance payments, thus avoiding the complex administrative and legal dismissal procedures.

41

CDDs were introduced in 1979. CDDs are also used for special employment programs targeted at the young and the long-term unemployed. The worker is then qualified for unemployment benefits, which start at 57.4 percent of the previous gross salary (or 40 percent of the gross salary plus a fixed sum) but decrease over time, depending on the age and the experience of the worker. This implies that workers can alternate between CDDs and unemployment spells, receiving unemployment benefits while unemployed.

42

The maximum duration can be extended to 24 months in very special cases.

43

This phenomenon is shared by a large number of European countries.

46

These EPL characteristics are shared by many European economies.

47

When the job destruction rate is exogenous, the labor market tightness (the vacancy/unemployment ratio θ) is independent of the unemployment rate u.

48

Opening a new job vacancy is not job creation, and is considered as creating a job vacancy.

49

Alternatively, the steady-state condition can also be stated in terms of job flows, instead of unemployment flows. Specifically, in the steady state, the rate of job creation (inflows into employment) equals to the rate of job destruction (outflows from employment).

50

Minimum wages in France apply to most wage-earners, irrespective of age and occupation. The government had in the past relied on increases in minimum wages to sustain consumption. Minimum wages in France began to rise sharply in relation to the median wage after the second half of 1960s and stayed high since the mid-1980s compared with its neighboring countries and the United States.

52

These EPL characteristics are shared by many European economies.

53

When the job destruction rate is exogenous, the labor market tightness (the vacancy/unemployment ratio θ) is independent of the unemployment rate u.

54

Opening a new job vacancy is not job creation, and is considered as creating a job vacancy.

55

Hence worker flows and job flows are assumed to be the same. According to Mortensen and Pissarides (1994), the introduction of on-the-job search should not alter the main results of the model.

56

Alternatively, the steady-state condition can also be stated in terms of job flows instead of unemployment flows. Specifically, in the steady state, the rate of job creation (inflows into employment) equals the rate of job destruction (outflows from employment).

57

In theory, fixed-term workers should be offered a wage premium that compensates for the higher separation risk, but there is no empirical evidence suggesting this. On the contrary, there is evidence indicating a wage penalty associated with fixed-term workers (see Box 1).

58

In this setup, wages are renegotiated continuously.

59

This can be interpreted as the firm and the worker having the same bargaining power.

France: Selected Issues
Author: International Monetary Fund