Education and the Welfare Gains from Employment Protection

This paper studies the impact of an European-like labor market regulation on the return to schooling, equilibrium unemployment and welfare. We show that firing costs and temporary employment have opposite effects on educational choices. We furthermore demonstrate that a laissez faire economy with no regulation is inefficient as it is characterized by insufficient educational investments leading to excess job destruction and inadequate job creation. By stabilizing employment relationships, firing costs may spur educational investments and therefore lead to welfare and productivity gains, though a first-best policy would be to subsidize education. However, there is little chance for a dual labor market, as is common in many European countries, with heavily regulated long-term contracts and more flexible short-term contracts to raise the incentives to schooling and aggregate welfare.