Elements of ‘efficient’ dismissal protection regimes

The conclusion that, under certain conditions, legislation may be superior in efficiency terms to mere private contracting does not yet answer the crucial question of which type of legislation is best suited to achieve these goals.

First, in order to provide a supporting structure for investments in relation­ship-specific capital and the private returns resulting from them, efficient dismissal protection legislation will have to be fashioned close to the sunk cost rules underlying private contracting in modern labour market settings. More specifically, this has a number of implications. In order to mitigate the risk of opportunistic behaviour, efficient dismissal protection regimes will contain clauses restraining employers’ freedom to dismiss workers ‘at will’ and tying individual employment terminations to the requirement of some objective and verifiable ‘just cause’, such as malperformance, shirking or misconduct on the part of the worker. Moreover, the risk of adverse selection of malperforming or shirking workers would seem to require the existence of a waiting or probationary period for newly hired workers, during which legal dismissal restrictions do not apply, thus allowing firms a careful on-the-job screening of novices without facing major termination restraints.

Risk sharing in the event of an economically induced decline in labour demand means that the firm retains the right unilaterally to terminate workers’ employment if a change in economic conditions requires it to do so, provided that, prior to resorting to lay-offs, the firm has ostensibly taken all ‘reason­able’¹⁰ efforts to prevent lay-offs through alternative forms of workforce and hours reduction, such as a temporary employment ban and/or work sharing. When lay-offs become inevitable, the existence of deferred compensation schemes to elicit work effort and worker commitment (which can be assumed to be given in one form or another in all large-firm settings with internal labour market structures), would seem to require efficient dismissal protection re­gimes to contain clauses demanding that junior workers will be laid off first (lay-off by reverse seniority) and that lay-offs of tenured senior workers in­volve severance payments as (partial) compensation for past work effort.

Second, in order to prevent externalities arising from private maximizing behaviour, ‘efficient’ dismissal protection regimes will include regulations forcing the private labour market parties to internalize the full costs of their rent-generating transactions. Generally, such externalities are given when the external costs caused by dismissals and lay-offs exceed the costs that the labour market parties would have incurred to prevent dismissals or lay-offs. In order to reduce external costs caused by lay-offs, ‘efficient’ dismissal protection regimes will include pre-notification requirements for non-disci- plinary dismissals, enabling workers to search for new employment while still on the job, thus reducing the burden to be carried by public unemploy­ment insurance schemes caused by frictional unemployment.

Another type of externality may result from strategies by firms and the majority of incumbent workers (‘insiders’) to systematically ‘weed out’ indi­vidual workers who are less productive, thereby raising their own stream of revenue and contributing to an increasing segmentation of the labour market between highly productive ‘insiders’ and less productive ‘outsiders’. In so far as such behaviour causes external costs exceeding the alternative (internal) costs of retaining such workers in the firm (as, for instance, in the case of pregnant women or older workers approaching retirement), legally imposed protective provisions raising the internal costs of dismissing such workers (for example in the form of special, tradable employment guarantees) may enhance overall efficiency.

Third and last, taking into account that the sunk cost rules characterizing modern employment relationships (as well as the adverse external effects of lay-offs) apply primarily to medium-sized and larger firms with internal labour markets, efficient dismissal protection regimes will further include selective exemptions for small firms which lack the scope and organizational structures to have recourse to alternative modes of workforce adjustment (such as attrition) and thus will face significantly higher costs due to dis­missal protection than larger firms.

It is no coincidence that the above theoretically derived principles of ‘efficient’ dismissal protection regimes in modern labour market settings largely correspond to the basic structure and components of actual dismissal protection regulations found in many European countries (as well as to ex­plicit or implicit practices voluntarily adopted by many large firms in countries without dismissal legislation, such as Japan and the United States): histori­cally, the introduction of dismissal protection legislation has been, as a common feature across many European countries, closely associated with the spread of internal labour markets and their typical concomitants of capital-intensive production, economies of scale, a high degree of division of labour, high costs of labour turnover and continuing firm-worker attachments. In fact, in those countries for which historical evidence is available, many of the rules and procedures required by dismissal legislation had already become com­mon practice in large parts of the economy before such legislation was first introduced or extended in the 1960s and 1970s. In these cases, legislation appears to have taken the form of a mere codification of widespread de facto practices that had evolved endogenously in dominant and advanced sectors of the economy (see Buechtemann, 1993).

Such a policy mode of legally codifying prevailing ‘best practices’ in­volves several advantages. First, by merely universalizing what the majority of firms practise in the absence of exogenously imposed legal constraints, it produces few additional costs as its immediate impact is confined to a min­ority of (idiosyncratic) firms whose personnel policies deviate from the predominant pattern, encounters little political opposition and induces little circumvention. Second, through legally codifying the (implicit or explicit) terms of the majority of permanent employment relationships, it largely avoids the efficiency losses incurred by a redefinition and reassignment of property rights that interfere with permanent market exchanges. Third, by immediately drawing on ‘efficient’ practices in advanced sectors of the economy, it avoids the problems and risks of regulatory failure due to legisla­tors’ information deficits about the functioning of real labour markets and overcomes the crucial problem of the ‘structural coupling’ (Teubner) between public policy, on the one hand, and the behavioural dispositions and reper­toires of economic agents, on the other.

Notes

1. Large parts of this entry are based on ‘Employment and dismissal protection’, by J. O’Reilly and K. Schomann in G. Schmid, J. O’Reilly and K. Schomann (eds) (1996), International Handbook of Labour Market Policy and Evaluation, Aldershot, UK and Brookfield, US: Edward Elgar.

2. Insider-outsider theories have shown, however, that - given market imperfections - such unconstrained agreements between firms and workers are not necessarily optimal in terms of overall economic efficiency, although they may be ‘efficient’ from the viewpoint of firms and employed ‘insiders’.

3. An exception is civil servants with lifetime appointments.

4. An exception to this rule is special dismissal protection regulations that apply to certain categories of workers, such as members of firm-level worker representation bodies (for example, the German works councils), drafted persons on military service, women during pregnancy and on maternity leave, as well as severely disabled persons. However, in most of these cases, there is also the possibility of offering protected employees severance pay in order to induce them to quit. Such special protective regulations, which are not dealt with in this chapter (but see OECD, 1994, pp. 173ff.), thus, in effect merely raise the costs of employment terminations and do not provide any absolute protection against job loss, as is illustrated by the case of plant closures and firm bankruptcies.

5. ‘Efficiency’ here simply denotes maximizing the output value derived from a given set and quantity of inputs.

6. It should be noted that most of these models assume transactions between formally equal market participants and a clear definition and assignment of initial property rights. Such property rights ‘establish the initial distribution of rights, the exclusivity of the rights, and the mechanisms under which transfers of property rights are effected and recognized’ (Spulber, 1989, p. 48). Without the assignment of clearly defined, exclusive property rights, market transactions cannot take place.

7. In a unique historical analysis, Carter (1988) has shown for the United States (California) that the duration of employment relationships and the importance of near lifetime jobs have significantly increased between the late nineteenth and the late twentieth centuries.

8. An empirical indicator of such inefficiencies due to unclear standards would be the number of dismissals that are legally contested through litigation (see, for example, Barnard et al., 1995, pp. 36f.).

9. An empirical indicator of growing inefficiencies of this kind could be the overall amount paid by employers in order to buy out protected employees (severance pay).

10. ‘Reasonable’ in this context would refer to all those measures that do not jeopardize the economic viability of the undertaking at large. In this sense, Cooter and Rubinfeld (1989, p. 1068) observe that ‘the “reasonable man” of the law is not very different from the “rational man” of economics’. Most legal dismissal protection regimes are based on the notion of a ‘reasonable’ employer.

11. Such ‘externalities’ resulting from private maximizing behaviour are frequently induced by the existence of external institutions, such as the public provision of unemployment or early retirement benefits without (any) (as in most European countries) or with incomplete (as in the United States) experience rating of employers’ unemployment insurance contri­butions: in the absence of special legal safeguards, for instance, in the form of checks on the causes of job losses and the economic necessity and inevitability of dismissals, such institutions create incentives for the labour market parties to deliberately negotiate terms between them that involve costs for non-participating third parties, such as public unem­ployment insurance or retirement schemes.

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