Risks and sources of policy failure
The existence of market failures does not imply that dismissal protection regimes as we encounter them today are necessarily ‘efficient’ in the sense that the overall benefits emanating from them exceed their economic costs.
Rather, as we have been able to identify several sources of market failure which, in the absence of regulatory interventions, lead to suboptimal results, we can also identify several sources of policy failure causing major inefficiencies and market distortions. Specifically, the following types of policy failure appear important in the present context.Design failures
Policy design failures occur when policy programmes interfere with the basic logic underlying efficient private contracting in labour markets, with the result of discouraging instead of encouraging mutual sunk investments in relationship-specific capital, or of preventing labour market transactions altogether. In the area of dismissal protection legislation, such policy design failures arise, for instance, when dismissal protection regimes are overburdened by distributional or social policy objectives that are not aimed at merely preventing externalities from private contracting. An example would be absolute employment protection regulations for certain groups of workers (such as severely handicapped workers or older workers): in the absence of supporting measures (for example, job creation schemes for the hard-to-place workers or training subsidies), such regulations force firms to bear fully the costs for worker protection and thereby violate the risk-sharing principle underlying efficient employment contracts. This is particularly so when special protection for such groups is not seniority-graded, that is, tied to relationship-specific investments that create a genuine economic interest in or rationale for stable employment relations, and does not include mechanisms (such as probationary periods) ruling out or at least reducing firms’ risk of adverse selection.
Absolute dismissal protection regulations of this kind, therefore, tend to induce unintended behaviour, such as discrimination against protected groups in firms’ hiring policies, thus creating typical insider-outsider problems. Another instance of policy design failures is to be seen in vague and unclear standards and rules that fail to establish clearly defined property rights and/or to specify modes of recourse and penalties in the case of non-compliance and which therefore are prone to giving rise to conflicting interpretations and costly litigation and creating a high degree of legal uncer- tainty.8 Finally, inefficiencies can also result from legal thresholds, such as employment-based firm-size thresholds that determine whether the firm is subject to statutory dismissal protection regulations or not. These thresholds produce inefficiencies (and frequently induce evasive behaviours by firms) in that hiring the one worker who raises the number of workers above the threshold causes the employment terms of all employed workers in the firm to change.Implementation failures
Another potential source of policy failures is the way in which public policy programmes, laws and regulations are implemented. In the case of dismissal protection legislation, implementation rests primarily with the labour courts (or corresponding publicly mandated arbitration institutions or tribunals) and with special public authorization agencies (for example, local labour offices for major collective lay-offs or special boards responsible for deciding upon the justification of dismissals of special groups, such as disabled workers). Here, too, an important cause of inefficiencies may arise from judicial decisions (or precedents set) by labour courts (or equivalent bodies) which, in concretizing uncertain legal norms, basically change the substance of laws (as compared to preceding judicial interpretations), thereby retroactively affecting existing property right definitions and assignments and - as far as such court decisions establish general precedents - altering the terms of all permanent employment relationships within the specific jurisdiction (see Hamermesh, 1993).
As in the case of legislative changes, the efficiency losses will be all the larger, the less judicial decisions are based on empirically grounded notions of ‘reasonable’ employer behaviour and the more they are explicitly or implicitly intended to shift the existing power relationship between workers and employers. In fact, the now vast body of (partly inconsistent) labour court decisions redefining legal standards and the ensuing high legal information costs and high degree of legal uncertainty have been at the very centre of recent criticism of legal dismissal protection by German employers. Another type of implementation failure results from long authorization or arbitration procedures, which, apart from causing costly delays for the labour market parties, frequently preclude certain remedies (such as reinstatement of unjustly dismissed workers) because situations have changed when a decision or settlement is finally reached. In fact, ensuring speedy and ‘professionally’ conducted arbitration procedures in unjust dismissal litigation has frequently been proposed as a rationale for the establishment of a system of specialized labour courts or arbitration agencies for handling dismissal disputes, such as exist in several European countries.Policy failures due to structural ‘misfit’ and institutional malcoordination One of the most frequent sources of policy failures is malcoordination between institutional incentives and legally required behaviours, on the one hand, and the changing opportunity structures as well as shifting behavioural dispositions and repertoires of economic agents (workers and firms), on the other. That is, regulatory interventions that may have been efficiency enhancing in a particular historical situation and under specific economic conditions cease to be so when economic circumstances and prevailing forms of economic organization change. Moreover, the behavioural incentives and signals emanating from public policy interventions may be affected by changes in the wider regulatory and institutional environment in which they operate.
For instance, enhanced market volatility and accelerated (exogenous) technological change may raise the costs of employment security to employers, thus reducing the latter’s interest in continuing long-term employment relationships. In such an environment, in which adjustment speed (‘time competition’) becomes a core prerequisite for sustaining competitiveness, the institutionally stabilized logic of internal labour markets underlying most existing dismissal protection regimes may indeed come into conflict with the requirement of a faster reallocation of labour and declining returns to investments in relationship-specific capital (for example, specific skills acquired by workers).The increasing ‘misfit’ between dismissal protection regimes and economic requirements and the ensuing inefficiencies are then seen as the result of a failure of public policy to adjust to changing economic conditions (‘institutional inertia’).9 A different situation is seen when institutional or regulatory changes in other areas (such as rising legal minimum wages) discourage mutual sunk investments in relationship-specific capital or facilitate (and thereby encourage) the circumvention of dismissal protection regulations (for instance through fixed-term contracts). Given uncertainty and bounded rationality, employers may, for example, prefer hiring workers on fixed-term contracts, thereby, of course, not only reducing the (potential) cost of employment terminations, but also forgoing the rents to be reaped from mutual sunk investments in the context of longer-term, open-ended employment relationships.
The above discussion of market and policy failures implies that assessing the impacts of dismissal protection legislation on labour market efficiency and overall societal welfare requires not only a detailed analysis of existing dismissal protection regimes and the characteristics of the various labour market settings in which they operate, but also a careful balancing of their costs and benefits. From a theoretical point of view, the latter must also include the development of well-grounded notions of the opportunity costs of existing dismissal protection regimes, that is, the likely costs and benefits of alternative approaches to managing the complexities of modern labour markets and modern employment relationships. It is clear that these are ideal standards and requirements which, as the result of operationalization difficulties and data limitations, most actual evaluation research cannot possibly fulfil. However, they define a set of theoretically grounded criteria on the basis of which the designs, methodologies and results of previous evaluation studies can be judged with regard to their relative capacity to yield reliable policy recommendations.