Fixed-term Contracts and Unemployment: an Efficiency Wage Analysis

Abstract

During the 1980s, many European countries introduced fixed-term contracts to fight high and persistent levels of unemployment. Although these contracts have been widely used, unemployment remains about the same after fifteen years. This paper builds a theoretical model to reconcile these facts. I analyze the labor market effect of the introduction of fixed-term contracts in an efficiency wage model. The form of incentive compatible fixed- term contracts and the firm’s choice of contracts are studied. Permanent contracts are the standard way to offer incentives, but fixed-term contracts are cheaper. This generates an externality, which can make employment higher in the system with only permanent contracts. As a consequence, from a social point of view, the share of fixed-term contracts is too large. Increases in the renewal rate of fixed-term contracts into permanent contracts lead to higher employment levels. The model highlights the interaction between different rigidities in the labor market. Aggregate employment and the share of temporary contracts are affected in the same way by firing costs and the flexibility of wages.