How Do Layoff Costs Affect Employment?

General equilibrium analyses of layoff costs have had mixed messages on the implications for employment. This paper brings out the economic forces at work in different frameworks and explains the disparate results. Since private agents perceive layoff costs as equivalent to a less productive technology, these costs tend to have negative employment effects in models with employment lotteries where the number of employed can be reduced at a low cost to individual agents because of the collective sharing of aggregate consumption. In search models where agents are left to fend for themselves, layoff costs have the opposite tendency of lowering unemployment when such costs reduce the amount of labor reallocation. Lower frictional unemployment is thus attained at the cost of a less efficient labor allocation. Matching models have this very same tendency under the assumption that layoff costs do not alter the relative split of the match surplus between firms and workers. In contrast, if layoff costs increase workers' relative share of the surplus, matching models tend to post sharp increases in unemployment in response to layoff costs.